Countercyclical Capital Regime

There has been much talk about the procyclicality of the Basel II and Solvency II type capital regimes.

There is a very simple alternative that was used for many years in Canada that would work most of the time.

The system was very simple.  It applied to common stocks as well as real estate.  In the following discussion, the common stock application will be the focus. It was not thought of as a risk capital system.  But it can be used for such, and can be quite effective to create a capital regime that accumulated more capital during booms and that can require less capital after a bust.  That is what is wanted for a Countercyclical Capital Regime.

For common stocks, the process was to add all capital gains and losses to the requires capital balance and then to release a steady percentage of the required capital balance into earnings each year.

To illustrate, lets look at a firm that in 1991 acquires $100M of equities in a S&P500 index fund that beats the index by exactly its expenses each year.  They use those assets to fund $65 M of fixed liabilities that for this illustration never change in amount.

Each year, they intend to dividend out 90% of the funds that they are not required to hold to support the $65 Million of liabilities or the required capital.   Their returns are as follows:

Now if the regulatory regime says that they need to hold 34% of their position as capital each year.  That regime is PRO CYCLICAL because when they have losses, they will also need to find funds somewhere to add to their capital in the years when they have large losses.  This sort of system usually means that they will need to liquidate some risky assets somewhere to release capital to fund this or some other shortfall.  They might just choose to stop funding this liability with equities therefore meaning that they sell their entire position into a down market thereby adding to the sales that drive down prices.

The table below shows what happens in that situation.

Now with the counter cyclical system that is described above, that situation does not happen.  For this illustration, the rule is set that the initial capital requirement is the same 34% as the previous example.  But after that, the capital requirement moves up and down with the gains and losses and releases from the capital.   The same rule of paying dividends with 90% of excess assets.

With this COUNTERCYCLICAL CAPITAL REGIME, you can see two things.  (1) What sort of countercyclical rule might have worked and (2) Why there will never ever be anywhere near enough will for an adequate countercyclical regime to actually be put into place.

  • The sort of regime that is needed is one that will build up capital in good times and allow lower capital in bad times.  In this illustration, the capital build up went as high as 72.3% of assets in 1999.  The bursting of the dot com bubble losses were all absorbed by the enormous capital cushion.  Then the Global Financial Crisis bubble burst in 2008 was also absorbed by the capital, driving the capital level down below 20%.
  • And that is why it will never happen.  Regulators will never be able to withstand the pressure to allow release more of the capital when it gets as high as 70%.  And they will never be able to agree that less than 20% capital is sufficient right after the market has shown that it can lose 37% in a calendar year (almost 50% for the 365 day maximum peak to trough.)

So here is a simple, practical countercyclical capital regime that was actually part of the Canadian system for many years.  It can work.

But if you try to propose something along these lines to one of the regulators who claim to be seeking an answer to this problem, they will say that they do not want something this formulaic.  They want there to be some discretion.

Does that mean that they think that they will be able to do better than this simple tested process?

Or are they simply being realistic and admitting that they have no political chance of staying the course with such a system so there is no reason to adopt.

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