Second, the “riskiness” of a bank’s activities and the liquidity of its funding can change suddenly and radically as market expectations shift. This means that what appeared to be an adequate capital or liquidity cushion one day appears wholly inadequate the next. Indeed, the Achilles heel of the Basel regime is the assumption that there is a constant capital ratio which delivers the desired degree of stability of the banking system. After the experience of the past two years, and a decade or more in which capital ratios fell and leverage ratios rose to historically unprecedented levels, banks need more capital to persuade investors to fund them. A larger buffer gives new creditors greater comfort that their claims will be met in future, without resort to the public purse. And rather than pay out dividends or generous remuneration, banks should use earnings to build larger capital buffers. But how much larger? We simply don’t know. A higher ratio is safer than a lower one, but any fixed ratio is bound to be arbitrary. One way of dealing with this problem is to require banks to take out insurance in the form of “contingent capital”, that is capital in a form that automatically converts to common equity upon the trigger of a threshold that kicks in before a bank becomes insolvent. If a bank’s regulatory core tier 1 capital – common equity – remained above the threshold, nothing would happen.
Roughly a tenth of banks’ current drawing capacity 10 is collateralised by assets referencing sterling LIBOR. Those assets include: securities paying a LIBOR-linked coupon, securitisations with embedded LIBOR-linked swaps; and LIBOR-linked loans, in either raw or securitised form. The Bank must be able to value and risk manage any collateral taken in its operations in case it has to take that collateral on to its own balance sheet in a default. As 2021 approaches, that will be increasingly difficult to do for some classes of collateral referencing LIBOR. In many cases, firms may choose to re-reference LIBOR-linked collateral to SONIA, either by amending its terms or by issuing new instruments. We can already accept SONIA-linked collateral, subject to meeting appropriate eligibility requirements. An alternative would be to ensure LIBOR-linked collateral includes adequate fallback language specifying an alternative rate in the event that LIBOR ceases to exist. The main 10  https://www.bankofengland.co.uk/-/media/boe/files/sterling-monetary-framework/annual-report-201819.pdf?la=en&hash=E4B7FDB6E9048DBD71F5C8CE4E00D3BE9F6A96A2 10  All speeches are available online at www.bankofengland.co.uk/news/speeches  10  challenge arises with any remaining LIBOR-linked collateral that matures after 2021 but lacks adequate fallback provisions – and we are today publishing a discussion paper seeking views on how best to respond in this situation, through some combination of rising haircuts and future eligibility restrictions. No immediate changes are planned. But we are seeking input on these questions from market participants, by 27 September, to help the Bank formulate clear and well-signposted guidance on its future approach.