The Fall and Rise of Debt: Bank Capital Regulation After the Crisis

Abstract

Under the Basel capital rules for internationally active banks, subordinated debt has always been permitted to contribute a part of the bank’s regulatory capital requirements. This is a surprising concession to banks, at first sight, since debt, as a liability, cannot contribute to equity (i.e., the surplus of assets over liabilities). The Basel approach is explicable only on the basis that bank capital is designed to protect short-term debt holders, who might ‘run’ on the bank and cause its collapse, rather than bank creditors as a whole. Long-term debt subordinated to the holders of non-subordinated debt could conceivably discharge this function. In the financial crisis, however, subordinated debt singularly failed to discharge this role. Because debt absorbs losses only when the company is put into insolvency (bankruptcy) and states were unwilling to contemplate the bankruptcy of banks, in most cases, debt did not in fact absorb losses as anticipated. Bail-out by the state pre-empted loss falling on creditors. An initial, and wholly to be expected, response on the part of the Basel III authorities was to downgrade the role of even subordinated debt in regulatory bank capital and in the new capital buffers which Basel III introduced. It was to be allowed only where the resolution authorities could write it down or convert it into equity (bail it in) in advance of insolvency. However, in a second phase of reform, bail-in debt seems likely to become a mandatory element in the newly devised procedures for resolving failing banks. Bail-in in resolution is changing from being a concession to banks, which want to issue debt, to a requirement imposed with the aim of giving resolution authorities sufficient room for manoeuvre to reorganise failing banks. Whilst the role of bail-in debt in future regulation is not secure – and has fierce critics – this constitutes a remarkable turnaround for a liability that was once seen as almost beyond redemption.