Capital quality and the illiquidity
premium – Capital quality
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Article by Malcolm Kemp – 27
Copyright (c) Malcolm Kemp 2010
Abstract and Contents
2. Capital quality
Current regulatory practice typically implicitly adopts the
premise that the value placed on a (positive) liability is independent of the
deemed health of the entity to which the liability relates in the situation
being tested for in the valuation computation. This contrasts with the approach
applied by regulators to a negative liability, i.e. an asset. A
financial service organisation can generally use different types of
asset to meet its regulatory capital requirements. However, regulatory practice
typically distinguishes between them, depending on the extent to which the type
of asset in question protects customers (e.g. policyholders, beneficiaries,
depositors etc.) in the various different circumstances in which the
organisation can find itself.
In particular, banks and insurers are usually required to
have their capital subdivided into tiers. Most types of paid-up
unencumbered equity capital (and reserves) qualify for the highest tier (i.e.
Tier 1). In the event of the organisation defaulting, providers of this type of
capital will typically get nothing back from their investment unless and until
all prior claims are honoured in full. Organisations are also allowed to have
some of their capital base formed by other types of capital (e.g. Tier 2
capital, which includes many types of debt or hybrid instruments), as long as
the instruments still rank below customer liabilities in the event of default.
Key to understanding the rationale for capital tiering is to
appreciate that some types of capital are less effective than others at coping
with what we might call a gone concern situation (e.g. where the
organisation has defaulted or is approaching default), even if they offer
similar protection to customers in a going concern situation.
For example, although companies can refuse to pay coupons to
bondholders and dividends to equity holders, the former typically triggers
default whereas the latter doesn’t. In ‘normal’ circumstances, when the
solvency of the organisation is perceived to be strong, the two behave broadly
equally in terms of providing security to customers (if both rank below
customer liabilities). However, in stressed circumstances equity capital offers
better protection than bond capital. The need to continue to pay contractual
coupons on bonds to avoid formal default may significantly limit the
flexibility that the organisation has to address its weakened financial
Regulators of banks and insurance companies typically limit
the proportion of total required capital that can be in the form of non Tier 1
capital. One of the responses of banking regulators to the recent credit crisis
has been to seek for banks to hold both more capital in absolute terms and also
a higher proportion in the ‘right’ sort of capital, i.e. with a higher
proportion of the (increased) capital base exhibiting a resilient nature.
Arguably, pension fund capital adequacy rules operate in a
similar overall fashion but using different terminology. We can view the scope
to ask for future contributions from the sponsor as effectively a form of
‘capital’ that the trustees have access to in the event of the fund itself
getting into difficulty. However it is a form of capital that is not generally
perceived to be of as good quality as actually physically holding assets within
the fund itself, particularly if the sponsor covenant is considered to be weak.
In such circumstances, recovery plans and the like take on added importance.
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