Monday, 5 January 2009

Unrealised P/L and Tier 4 capital

Mark to market is great. It gives the users of financial statements the best information available about the value of a company. But, as we have seen over the last year or so, it also has the drawback - at least when applied to banks and such like - of encouraging procyclicality. On the way up, mark to market gains, once audited, form retained earnings, and so contribute to capital. This capital can then support more risk. On the way down, losses reduce capital and so inhibit risk taking just when it is vital for the economy that financial institutions to step up to the plate.

So.... let's split the link between unrealised gains and retained earnings. Specifically, I propose splitting the retained earnings component of tier 1 into two pieces. The first, retained realised earnings, would be as before. The second, retained unrealised earnings, would be the sole component of a new class of capital, tier 4. (Tier 1 is equity and highly equity like capital; tier 2 is reserves and certain types of long term sub debt; tier 3 is short term sub debt.)

Unrealised gains and losses would change tier 4. There would be constraints on the total amount of capital that could come from tier 4, just as there is today on the total that can come from tier 2. Exactly what would work needs some research, but my guess is that, say, having a rule like tier 1 must be 8 times bigger than tier 4 would work. On the way up, this would restrict the benefit available from unrealised gains. That buffer would then be available to absorb losses on the way down without restricting risk taking.

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