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Should Disaster Risk Lead to Increased Capital Requirements?
At the end of this March, I released a post where I called for an urgent integration of disaster risk management (DRM) into macro-prudential supervision, explaining the reasons for doing this, and giving a set of examples of how this can be achieved by both financial institutions (FIs) and their regulators/supervisors. I did not touch directly the issue of possible impacts on capital requirements, even if some of the measures proposed could be seen as hints at this. Let’s now address this difficult issue, which has no simple answers, while trying to keep it simple.
Before going further, let’s put it clearly: when a country’s GDP and its future growth can significantly be impacted by disasters, the FIs and their regulators/supervisors should definitely ask themselves if they and the financial system at large are resilient enough to withstand sizeable natural disasters or not. Even if this is not the case (i.e.: no significant impact on overall GDP, even when a significant number of people is affected) there may be a number of FIs which could run severely into trouble if their loan portfolio is heavily concentrated in areas prone to suffering frequent natural disasters; this could even happen in developed economies (just think of being a Florida-only bank, for example), but is not difficult to find in several emerging and developing countries, like Peru with its Northern coastal regions.
I can easily imagine some people already thinking: oh, no! This guy is intending to propose an across-the board add-on to existing regulatory capital requirements for FIs, so as to take into account disaster risk!
Well, the answer is no, it is much more complex than that. And I will explain why.
. First, in some emerging countries, capital levels and even CET1 (common equity tier 1) are already high, and even higher than those requested by regulators/supervisors, who have already determined high levels of required capital, through mechanisms such as Pillar 2 of the Basel II accord or with a long standing macro-prudential view that may even be older than Basel III. The leaders of a number of those FIs already know that their risk profile calls for higher capital, even if in many cases, regulators/supervisors are to be credited with having raised awareness among FIs about the importance of high levels of capital so as to better resist financial crises, which can be caused or worsened by natural disasters and not only by local macro-economic mismanagement, civil/external wars, or regional/global financial crises. This is notably the case in Turkey and in Peru, where you can find that the majority of FIs have total capital adequacy ratios (CAR) higher than 15 %, with CET1 or at least Tier 1 capital beyond 10 %; in Turkey, it can be added that the average CAR has even been above 16% and Tier 1 ratio above 14 % even if “target ratio” for capital is 12 % according to an end-2015 “peer review” conducted by the Financial Stability Board (FSB); in Peru, the SBS, the financial regulator/supervisor used to have target ratios of 10.5 % for banks and 14 % for MFIs, but with the authority it has since 2009/2010 to request enhanced capital ratios with a Pillar 2-type rule, quite a number of FIs (mainly MFIs) have had to reach levels closer to 20 % due to their risk profile.
. Of course, one may say: that’s OK, but what if a huge earthquake hits a city like Lima or Istambul (or for any other countries where a specific region or city exposed to serious natural hazards represents a very sizeable chunk of GDP?); capital requirements should be even higher! To the tune of 25 % or 30 %, for example. Well, that could be some kind of exaggeration. Because, unless you believe in theories such as “limited-banking” or call deposits used to make loans being “unlawful” (as some economists do), the CARs that have been reached in some countries already make their financial systems reasonably resilient even to extreme events; if you determine that CAR and Tier 1 (or CET1) ratios must reach the levels needed for the most extreme scenarios, there is a risk, at the macro level, of hindering economic growth during the “normal” years, as well as the possibility for the FIs to reach profitability levels that contribute to reinforcing their capital base (unless they charge much more, which would reduce access to credit for most people). And you keep FIs from being attractive enough for equity investors in their IPOs or Rights Issues.
This is a balancing act: either you try to be 100 % protected against any event, and you considerably reduce your own activity at the expense of future growth and social improvement, or you try to be reasonably protected, so as to reduce the risk of having to rescue the financial system in case of an extreme event such as a very large disaster (and try to reduce the cost of doing it if needed). You cannot always be 100 % sure of everything, otherwise no one would invest or lend, and well, choosing to remain a poor country with most people under the poverty line is not an option I would recommend; credit has always been an important driver of economic and social development, even if excesses have happened from time to time as financial and economic history show.
In short, even if disaster risk should never be seen as a tail-risk, as I have already written in the previous a/m post, one must also take into account that you do not have very large disasters happening all the time. Extremes should be avoided. Sometimes, when something bad happens, there is a tendency to fall into extremes in terms of financial regulation and other measures, thus making future recovery more difficult. Even if what I say certainly would sound “politically incorrect”, you can never be 100 % sure of avoiding the risk of having the central banks or the Governments obliged to rescue some FI; better to concentrate on designing mechanisms of doing it in ways that reduce “moral hazard” and so as to strongly discourage blatant risk under-estimation, or malpractice and bad behaviour; some key and hard, high profile measures are more efficient than overloading FIs with hundreds of new reports and obliging them to become “red tape” institutions also falling into excessive “de-risking”, which only ends up favoring shadow banking and organized-crime penetration of finance (such as some types of loan-sharking).
That’s why, together with solid CAR requirements, making sure that there are also good liquidity management rules and no under-weighting of risky assets in CAR calculations (an often-forgotten issue) and with other solid macro-prudential measures, and good bank resolution systems, measures such as those proposed in the March 2017 post, aimed at better addressing the issue of disaster risk should be enough. It is more a matter of fine-tuning and creating the incentives not to forget that disaster risk is real and must be addressed and that in some countries, or regions, remaining with low levels of insurance coverage is highly imprudent, to say the least.
Of course, if capital levels of FIs are rather low in countries heavily exposed to natural hazards, unlike the two countries given as an example, their Authorities should feel somewhat concerned; in some cases, increasing capital requirements, whether at a national, or a regional level, or for individual FIs, may be neeeded anyway. And even in those countries with high CAR levels, there is always room for improvement in the road to substantially reducing the risk of FIs’ rescues in case of a large disaster (supervision at the micro level, taking into account regional specificities, and DRM and DRFI techniques which make easier a speedy recovery in such a scenario, for example); even the most advanced countries have still some homework ahead in this field.
For many countries, even those with solid CAR regulations and practices, the issue of better integrating DRM into FIs practices and into macro-prudential regulation and supervision remains urgent. One cannot rely only on luck (like a strong hurricane changing its path as we have just seen in Florida). I hereby remind the link to the previous March 2017 post so that you can get the full picture of these proposals.