Bank capital and cryptocurrencies

The BIS’s draft proposals for capital regulation of stablecoins and cryptocurrencies have just been released. The headline proposal was a risk weighting of 1250% for what the BIS called “Group 2 cryptoassets”, which includes all cryptocurrencies, all algorithmic stablecoins, and reserved stablecoins  that don’t meet the capital, liquidity and disclosure requirements for “Group 1 cryptoassets” specified in the same document. Bitcoin and Ethereum, the two major cryptocurrencies, would fall into Group 2, along with most existing stablecoins. 

The proposals were widely misunderstood in the crypto community. As ever, much of the misunderstanding was about the nature of bank capital. 

Many people confuse bank capital with reserves. Reserves are cash deposits at the central bank and vaulted currency. They enable customers to withdraw cash and make payments out of their deposit accounts. Without them, banks would have to go to the market for funding every time a customer withdrew money from their account. 

Banks famously don’t keep enough reserves to enable all customers to withdraw all their funds all at the same time. Reserve requirements aim to ensure that a bank has sufficient liquidity to meet normal payment requests. The proportion of reserves to deposits that regulators require banks to keep is called the “reserve requirement”, and it varies from jurisdiction to jurisdiction and in some cases even from bank to bank. 

The most famous reserve requirement is the Federal Reserve’s 10% of eligible deposits, which is the foundation of the well-known “money multiplier” model of bank lending. Sadly, it is no more. It was abolished in March 2020, superseded by the Basel Committee’s liquidity regulations and additional Federal regulations such as living wills, and rendered obsolete anyway by the enormous excess reserve balances banks are carrying because of QE.

But although fewer countries have formal reserve requirements now, banks these days are far more liquid than they were prior to the 2008 financial crisis. The risk that they will literally run out of money and have to close their doors is much lower than it was at the time of the run on Northern Rock. 

Banks also have far more capital than they had before the 2008 financial crisis. But capital is not about liquidity. It’s about solvency. Capital requirements aim to ensure that banks don’t become insolvent when asset prices fall or borrowers default. The whole point is to prevent any repeat of the taxpayer bailouts of 2008. I’m astonished how many people don’t seem to know this.

Capital is on the opposite side of the balance sheet from reserves. This is the basic balance sheet equation: 

Assets = Liabilities + equity

Equity is not cash or assets. It is the difference between total assets and total liabilities. It is typically made up of shareholders’ funds, retained earnings and  general provisions. Bank “capital” is equity plus certain types of subordinated and convertible debt. 

Bank capital is often called “loss-absorbing” capital. This means that in the event of asset prices collapsing or bank loans defaulting, the bank’s shareholders and junior bondholders bear the  losses, not depositors, senior creditors or taxpayers.* You could regard it as a form of collateral.

If a bank doesn’t have enough capital to meet regulatory requirements for the assets it holds, it must either dispose of some of the assets or raise additional capital. Raising capital could mean rights issues and/or issuing convertible bonds or some forms of subordinated debt. Deposits are not capital, and neither are senior bonds. Importantly, convertible and subordinated debt generally doesn’t count towards the bank’s core Tier 1 capital, the capital that is first in line to take losses. Banks can’t borrow their way out of insolvency. 

Now to the Basel Committee’s proposed capital requirements for crypto assets. The committee divides crypto assets into two groups: 

• Group 1: tokenised assets (Group 1a) and fully reserved stablecoins (Group 1b). The committee proposes a draft regulatory framework for these assets. 
• Group 2: cryptocurrencies, algorithmic stablecoins, and reserved stablecoins that don’t meet the capital, liquidity and disclosure requirements for Group 1b.  

The widely-reported 1250% capital weighting applies to Group 2 cryptoassets. The Basel Committee has decided that because cryptocurrencies have no intrinsic value and are highly volatile, the risk of total loss is considerable. Banks must therefore have sufficient capital to ensure that there is no risk of insolvency in the event of a total loss. 

That capital weighting looks wild, but is explained in this footnote to the Basel Committee’s paper:

So, for banks that meet the Basel minimum capital requirement, the 1250% weighting is equivalent to 100% equity collateralisation of Group 2 cryptoassets. However, most banks nowadays have more capital than the 8% minimum. For them, the 1250% weighting is overcollateralisation.

To give an example: in 2020, JP Morgan’s capital ratio was 13.1%. Applying this to the Basel formula I tweeted earlier translates into capital of $163.75 for every $100 of Group 2 cryptoasset exposure. That is significant overcollateralisation.

This capital requirement applies to both short and long positions. There’s also a recommendation that supervisors apply an additional capital requirement to short positions because potential losses are unlimited:

* I have considerably simplified capital requirements for the purposes of this post. In practice, losses might not be borne entirely by shareholders: subordinated debt holders might also suffer losses, and under some circumstances, holders of convertible bonds (“cocos”) can bear losses before shareholders are affected.