Capital adequacy approach to bank soundness is fundamentally flawed

THERE is a fatal flaw at the heart of approaches to bank soundness, which seek to insure against insolvency by requiring banks to hold capital sufficient to provide cover for any risk that the regulator considers possible.

Bank capital is the difference between the value of assets and the value of liabilities, both determined in the market. In times of financial crisis, markets often fail and prices fall precipitately. It will not usually be the case that price changes affect both sides of any bank’s balance sheet equally. If the fall in the price of assets reduces their overall value sufficiently relative to its liabilities, the bank faces insolvency, no matter how large its stock of capital might be.

This is the phenomenon we have seen in the sensational financial failures of FTX, Silicon Valley Bank and Credit Suisse. Whatever the source of concern, it is the loss of asset value which triggers the failure of the institution.