Also, once a firm has run into trouble, in part because it is in trouble and/or markets are dysfunctional, the marketable value of its assets are often found to be substantially less than valued in accounts – so losses are usually greater than originally expected, once a stress has occurred. Prior to the financial crisis, firms appeared to hold substantial capital to meet their then regulatory requirements, but in many cases this was illusory – the rules on what could count as capital had been weakened over time and much of it was not properly or easily lossabsorbing in the event. So the quality of capital is also of interest. There is also a challenge of what the minimum level of acceptable capital is, and how to meet it, post-stress. Suppose X is the appropriate level of capital pre-stress, then substantial losses will always leave a firm  BIS central bankers’ speeches  3  with significantly less than X. And raising extra capital in the market in those circumstances is not always feasible, nor can a balance sheet be quickly run down to reduce capital requirements. So how can a firm meet the ongoing requirements for the normal level of capital after a stress event? The answer is usually to start with a buffer above the minimum acceptable and/or to have some way of creating extra capital in a crisis.
Different firms can assess risk by different methods and models, using different data sets or applying different judgements: assessments undertaken by the BCBS1 have shown firms can generate quite different RWA calculations for an identical hypothetical portfolio. And firms may choose to optimise both their choice of assets and the weights attached to them to minimise capital requirements. It has been shown that differences in capital ratios calculated on an RWA basis have historically had little or no correlation with whether firms were able to survive a 1  4  Basel Committee on Banking Supervision July, 2013. “RCAP – Analysis of risk-weighted assets for credit risk in the banking book”. BIS central bankers’ speeches  stress2. A leverage ratio offers an alternative approach, which is not risk sensitive but simply calculates total capital in relation to total assets. The degree of leverage has historically been a much better indicator of likely firm failure (although we can’t be sure that correlation will survive if firms start to manage to a constraint!). As alternatives, the RWA and leverage approaches would generate different incentives for firms to be capital efficient. Under RWAs the incentive can be to expand the balance sheet with assets that carry low risk weights. Under a leverage ratio, the incentive can be to limit balance sheet size but choose riskier assets. Ideally, the two measures would work in tandem to ensure sufficient capital to support both balance sheet size and risk taking.