A great piece here by Jonathan Ford of the FT. For those on the wrong side of the paywall, his case is as follows.
The Bank intervened last week to stop banks paying out dividends, the official reason being the coronavirus panic. But why didn’t the Bank prevent capital distributions earlier, given the much-heralded capital rebuilding exercise? Ford argues that the official measure of capital strength, CET1, may be illusory, given that it is based on ‘risk weighted assets’, a subjective and hence gameable measure of asset value.
A less gameable measure involves comparing equity not with a RWAs, but simply the total unadjusted asset number. Moreover, because accounting measures of book equity are backward-looking and may conceal losses, it makes sense to use the bank’s market capitalisation in their stead — especially when events are moving fast.
He quotes our own Professor Dowd saying that Barclays’ leverage ratio (equity divided by unadjusted asset value) is now just 1.2 per cent.
I expect Kevin will comment later, my issue today is the comments to Jonathan’s article, which reveal a common misunderstanding about the nature of equity capital.
There were comments such as DAC (April 7, 9:18), saying that ‘Market value has nothing to do with equity,’ and Solvency guru (April 5, 20:39) saying ‘Using market cap as a meaningful comment on solvency is very strange- “apples and pears”’. There was Investor123 (April 5, 20:39) claiming that ‘once the money has been contributed in the form of *primary* equity capital, that money – which provides the buffer to withstand credit losses – doesn’t somehow get taken away when the *secondary* market price of those partial interests (ie. shares) falls in value.’
These comments (and others) are forms of what John Vickers calls the holding capital fallacy, the fallacy that capital is a form of asset, held in reserve for a rainy day or for an epidemic, as a ‘buffer to withstand credit losses’.
It is indeed a fallacy. Equity capital is not an asset but a form of liability, being an estimate of net assets – what the company would owe to its owners in the event of the assets being sold and all debt paid off. Equity is loss-absorbing precisely in the sense that any fall in the value of the asset side is mathematically a fall in net assets, hence a fall in the liability to shareholders. Equity absorbs asset losses by absorbing liabilities to shareholders. By contrast, debt is not loss absorbing, because its contractual value remains the same whatever the value of the asset side. If I have a debt of £90 and the asset value falls to £80, I still owe my creditor £90.
From this it should be clear that market capitalisation and book value are not apples and pears, for they aim at measuring the same thing, the net asset value. The only difference is that accountants estimate the value of net assets as of year end, publishing them typically in March or April of the following year, whereas the equity markets estimate them daily, based on new information as well as the outdated year-end accounting information.
Hopefully that clears up the fallacy. A further confusion is about the nature of regulatory capital, which I will discuss tomorrow.