Capital quality and the illiquidity premium – Capital quality

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Article by Malcolm Kemp – 27 May 2010

Copyright (c) Malcolm Kemp 2010


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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 position.


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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