In the GT Alert we produced in September, we commented on the inquiry the Financial Services Regulation Committee (the Committee) of the House of Lords commenced on non-bank financial institutions (NBFIs). One of the main questions that the Committee is considering is whether the regulatory capital regime that applies to banks was inhibiting bank lending to the real economy, resulting in the growing importance of NBFIs as a source of credit.

In this GT Alert, we consider certain views witnesses appearing before the Committee have expressed on the topic of regulatory capital.

What Is Regulatory Capital and Why Is it Needed?

All businesses arguably take risks, and profit is the return a business earns for risk taking. A manufacturer of widgets is engaged in the business of making and selling its products. It will take risks on the availability and costs of its raw materials, the availability and costs of the labour it requires, tastes and fashions in the market for widgets, the development of more technologically advanced widgets, the impact of macro-economic factors on the demand for widgets, and so on. These risks are necessary incidents to its core business of making and selling widgets, but they are not its core business. The business of providing credit is different because it involves an entity (the lender) earning profit (interest) from taking the risk that another entity (the borrower) will not make the payments of interest and the repayment of principal that it is required to make. In other words, the business of providing credit involves a lender earning a profit because it is willing to take credit risk on the borrower by lending money to it. Taking credit risk in the expectation of earning interest is the business of a lender.

The fundamental difference between banks and NBFIs is the way in which they fund the loans that they make. At a simplified level and recognising that this is not a universally held view, banks act as financial intermediaries, making loans using funds that are deposited with them by their customers. This is both a unique privilege and a unique problem because, though banks, in the ordinary course, have a continual supply of depositors’ funds, depositors are entitled to ask their banks to return their deposits, either on demand or subject to certain conditions. Ignoring for these purposes the inherent duration mismatch between long-term loans and short term deposits, if a bank has used all its deposits to make loans and is relying on its borrowers to pay interest and repay principal in order be able to honour its obligations to depositors, any failure of a borrower to perform its obligations means that the bank may not be able to pay its depositors should they want their money back. In that scenario, the solvency of the bank may be compromised and a run on the bank may follow. It is partly in order to protect depositors, and indeed other creditors, that banks are required to have a certain amount of regulatory capital. In simple terms, regulatory capital may be used by a bank to enable it to honour its obligations to creditors even if a certain proportion of the loans it makes do not perform as expected. To put it slightly more technically, regulatory capital may be used to absorb losses arising from borrower defaults before depositors are impacted by these losses. Losses are a natural incident of lending, and so the need for loss absorption makes regulatory capital important. Depositors also have protection (depending on the quantum of their deposits) from compensation schemes such as the Financial Services Compensation Scheme in the United Kingdom.

As well as absorbing losses, another purpose of regulatory capital is to provide some comfort that regulated institutions hold enough resources to facilitate their orderly winding up if they are in the position of having to enter into an insolvency process.

One of the first witnesses to give evidence to the Committee, Professor Simon Gleeson, generally recognised the need for banks to hold regulatory capital and to be regulated more stringently than NBFIs. In this part of his evidence, Professor Gleeson stated:
 

While certain NBFIs such as insurers and pension providers fund their lending activities using insurance premia and pension contributions, debt funds use capital provided by their investors specifically to fund their lending activity. The bargain that these investors make with debt fund managers is fundamentally different from the bargain that depositors make with a bank: they provide capital to debt fund managers because they wish to earn a profit from the loans that the debt fund manager makes and they are able to assess the debt fund manager’s professional experience and skill before providing it with capital, as well as defining the extent of the debt fund manager’s investment mandate. In other words, an investor in a debt fund is able to make an informed decision before it puts its capital at risk.¹ A customer of a bank, depositing funds with it, undertakes no such assessment and indeed has no visibility or control on what use a bank is making of its funds. Professor Gleeson offered additional evidence on this distinction:
 

In addition, and as Professor Gleeson noted, banks also provide much of the “plumbing” for the financial system, whether it be through the transfer of funds from one person to another, either with debit cards or electronic banking. NBFIs, which provide credit, generally do not do this. 

Does the Regulatory Capital Requirement Give NBFIs an Unfair Advantage?

Regulatory capital requirements for banks exist within the current financial regulatory framework. It is, however, necessary to understand how regulatory capital requirements are calculated and why the amount of regulatory capital may impact banks’ lending activities.

In simple terms, banks, like any enterprise, must pay those who provide it with the means to undertake business. Banks will generally pay depositors some level of interest. This is relatively inexpensive as a funding source, particularly where depositors have the benefit of state-backed deposit insurance and where they may withdraw funds on demand. Equity, on the other hand, which is the “best” form of regulatory capital, is expensive, given that providers of equity are in the “first loss” position in a bank’s capital structure, meaning that they will lose all of their investment before depositors lose any of their deposits. Thus, the more regulatory capital a bank is required to hold, both overall and for any lending activity, the more it needs to earn from borrowers. This, in turn, may have an impact on whether it can provide borrowers with competitive terms relative to NBFIs. In addition, without sufficient regulatory capital being available, a bank may not be able to lend on any terms.

The amount of regulatory capital that banks are required to maintain was commented on by Mr Mark Steele, Chief Risk Officer of OakNorth Bank, in evidence that he provided to the Committee:

There are three noteworthy elements in Mr Steele’s evidence. The first is that not all banks are the same in terms of systemic importance. Smaller banks, with less systemic significance should not, in Mr Steele’s view, be treated the same way as systemically significant banks, from a regulatory capital perspective. The second is that the regulatory capital requirements imposed on smaller banks may exceed the losses that it has suffered on loans that they make, suggesting that the regulatory capital requirements are excessive compared to “economic capital.” The third is that the more risky a particular loan or type of loan is perceived to be, the greater is the regulatory capital requirement ascribed to it. This makes certain types of lending, such as lending to fund property development, particularly capital consumptive and therefore expensive. This means that banks, notwithstanding the advantage of having access to low-cost depositors’ funds, may not necessarily be able to provide credit for certain purposes competitively and, in these cases, NBFIs may be the more efficient, or indeed in some cases only, source of credit. 

What Does This Mean?

From the perspective of practitioners, the evidence that we have referred to in this GT Alert has three practical implications:

• that there appears to be a justification for regulatory capital requirements being imposed on banks given the funding provided to them by depositors and the other services they provide to the real economy, which may make them systemically important. NBFIs are not in the same position, and so the difference in treatment from a regulatory capital perspective is arguably logical;
   
• that, based on the rules that apply currently, the amount of regulatory capital that a particular bank is required to maintain may exceed, by a considerable margin, the economic capital that it requires to absorb losses and may be disproportionate to its systemic importance; and
   
• excessive regulatory capital requirements may inhibit bank lending or increase its costs. There may be good reason to consider the approaches used to quantify regulatory capital requirements, based not just on types of lending but also the systemic importance of a particular bank, as well as the risk-management approaches that it adopts.

That is not to say that NBFIs do not have systemic importance. One of the topics that the Committee is considering is the interconnectedness between NBFIs and banks and whether financial distress in the former sector might result in financial distress in the latter. However, imposing regulatory equivalence between banks and NBFIs may restrict the availability of credit for certain activities.

The work of the Committee continues, and the deadline for public comments has passed.