S9 Ep21: The Bank of England's capital mistake?

Episode Summary

Executive Summary: The episode examines the Bank of England Financial Policy Committee’s decision to lower UK banks’ equity capital benchmark from 14% to 13%, which guests David Aikman and John Vickers argue is a mistake. They contend that higher capital improves resilience at little or no long-run cost, that crisis risks remain elevated, and that easing the backstop may signal broader deregulation and encourage more leverage and payouts rather than more lending.

Main Topics: Why bank equity capital matters (Priority: 5/5): John Vickers explains that equity is the key loss-absorbing buffer for banks and that insufficient capital was central to the 2008 crisis. The FPC’s post-crisis capital framework (Priority: 5/5): David Aikman describes the Financial Policy Committee’s role as the UK’s macroprudential authority and its 2015 decision to set a 14% capital benchmark. Why the 2025 cut to 13% is controversial (Priority: 5/5): The guests argue the Bank of England’s 1 percentage point reduction is directionally wrong given greater uncertainty after Brexit, the pandemic, and fiscal strain. Costs versus benefits of higher capital (Priority: 4/5): Both guests challenge the idea that more equity is economically costly, arguing gradual increases need not reduce lending and may be close to a free insurance gain. Leverage ratio backstop as an alarm bell (Priority: 4/5): They warn that if the leverage ratio becomes binding, regulators should question risk-weighting models rather than simply weaken the backstop. International and political pressures (Priority: 3/5): The discussion links the move to growth priorities, industry lobbying, and global deregulation trends, especially in the US and Europe. What banks may do with extra headroom (Priority: 3/5): The guests note banks may use lower requirements to support dividends and share buybacks rather than expand lending.

Key Arguments: Equity capital is the most reliable loss absorber in bank funding structures, so higher levels improve resilience against shocks. The 2008 crisis showed that capital ratios of only a few percent left banks dangerously leveraged and amplified damage to the wider economy. The FPC’s 2015 14% benchmark was already optimistic because it relied heavily on confidence in resolution regimes and regulators’ ability to spot risks early. A 1% cut to 13% is not trivial; it could free roughly £30 billion of capital and signals a more deregulatory stance. The world is more uncertain now than in 2015 because of Brexit, COVID-19, and a weaker fiscal position, so the benchmark should arguably rise, not fall. Higher capital is not clearly costly: if introduced gradually, it may not reduce lending and could be close to costless insurance. If the leverage ratio backstop is binding, that may indicate risk weights are underestimating risk, especially for bank exposures to non-bank financial institutions. Lower requirements may mainly increase shareholder payouts rather than productive lending, so deregulation should not be assumed to boost growth. The UK should be cautious about following international deregulation trends if the downside costs of another crisis would fall on the UK economy and state.

Data Points: UK capital benchmark: 14% - The FPC’s earlier benchmark for banks’ equity capital requirements, set in 2015. New UK capital benchmark: 13% - The FPC’s December 2, 2025 decision lowered the benchmark by 1 percentage point. Capital reduction size: 1% of risk-weighted assets - The announced cut in the benchmark level. Estimated capital amount: about £30 billion - Approximate amount of capital the 1% reduction could release if banks lower ratios. Post-crisis bank equity levels: 2% to 3% - John Vickers cites how low some major banks’ equity capital was before the 2008 crisis. Leverage implied by low capital: 40x - A 2.5% equity ratio corresponds to roughly 40 times leverage. ICB preferred extra buffer: 3% of risk-weighted assets - Vickers says the Independent Commission on Banking wanted the FPC to use the full parliamentary scope for big domestic banks. Implementation timing: beginning of 2027 - The Basel 3.1 package is expected to be implemented then, affecting how the new benchmark is transmitted. Time since crisis: 19 years - The transcript notes the long gap between the 2008 crisis and Basel implementation in 2027. Potential GDP gap: 25% bigger - A parliamentary-report-based illustration of how much larger UK GDP might be if pre-crisis trend growth had continued.

Pivotal Quotes: "It’s signalling that the bank is now in a more deregulatory phase, or at least that would be the concern that I have." — David Aikman: On the broader meaning of the FPC’s decision to lower the capital benchmark. "If you weaken the backstop, what does it then mean to be a backstop if you’ll weaken it when it begins to bind?" — John Vickers: On the leverage ratio cap and why easing it could undermine the purpose of the safeguard. "The insurance that David talks about might be an absolute freebie." — John Vickers: On the argument that higher capital requirements necessarily harm growth.

Implications: The episode warns that easing bank capital rules may increase systemic risk without delivering growth. Listeners should expect continued debate over leverage ratios, Basel 3.1, and whether UK regulators are prioritizing competitiveness over resilience.