The Bank of England announces plans to make banks safer

The Economist. Nov 8th 2014.

In 2008 Royal Bank of Scotland (RBS) was bailed out with £45.5 billion ($79 billion) of taxpayer funds, or £741 for every British citizen. The bank’s capital base had been insufficient to absorb heavy losses, in part because of regulatory lenience. When loans and investments began to turn sour, a costly rescue became necessary.

On October 31st the Financial Policy Committee (FPC) of the Bank of England made a long-awaited announcement on the leverage ratio, one of several new measures intended to guard against a repeat of the RBS episode. A bank’s leverage ratio gives the proportion of its assets funded by equity capital (which absorbs losses) rather than debt or deposits (which do not). Crucially, it is a measure of the losses a bank can sustain before its shareholders are wiped out, causing it either to fail or to rely on hybrid instruments—mixtures of debt and equity—which are unproven.

Banks borrow more than other companies: the average leverage ratio of non-financial FTSE 100 firms is 37%. There are many reasons for the disparity. One is particularly pernicious: big banks can expect to be bailed out if they fail, so their debt is cheaper. This implicit subsidy is in the sights of regulators like the FPC. As capital requirements increase, the probability of failure falls, and with it the subsidy.

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