Yesterday, I began to set out how my proposed Financial Institutions (Reform) Bill would meet the need for a vibrant, reliable and robust banking system by adjusting bank directors’ and employees’ exposure to commercial risk.

That article described changes to bank directors’ liability and the treatment of bonuses. This article explains how losses would be made good and defines core capital.

3. Use of personal bonds and bonus pool to make good bank losses

3.1 Should a bank report losses over any period, these losses would be made good in the first instance by drawing from the bonus pool. This will further discourage excessive risk-taking: accumulated bonuses would be not just in line but first in line to cover any losses.

3.2 So, if a bank reports a loss equal to,say, 50% of the value of the bonus pool, then 50% of the bonus pool would be liquidated and transferred to the bank to cover those losses. Each beneficiary of the bonus pool would lose half his/her claims on it.

3.3 Should a bank report losses that exceed the value of the bonus pool, then the whole of the bonus pool would be forfeit to the bank to make good the losses. The difference remaining – the difference between the reported loss and the value of the bonus pool – would then be made good by drawing from the board members’ personal bonds. Should their bonds prove insufficient to meet the whole of the remaining loss, then all their bonds would be liquidated to offset that loss, and any subsequently remaining losses would be passed to shareholders.

That is, any losses in the first instance are to be borne by beneficiaries of the bonus pool; further losses are to be borne by board members and made good from their posted bonds. Any further losses are then to be borne by shareholders in the usual way. Finally, in the event of insolvency, directors are exposed without limit.

This means that we would have three different types of bank core capital, with the bonus pool being the most junior, the personal bonds being the second most junior, and equity capital being senior. The most junior capital absorbs any initial losses until that level of capital is wiped out, the second most junior capital absorbs any further losses until it is wiped out, and so forth.

The reason why the bonus pool is made most junior is to ensure that the primary risk-takers bear the first losses, thus giving them the strongest incentives not to take excessive risks, bearing in mind that they would not be subject to the personal liabilities to which board members are to be subjected.

3.4 In the event that board members’ personal bonds are forfeit to the bank, board members would be required to replenish their personal bonds within a specified short period.

4. Definition of core capital

The core capital of the bank would be the sum of the shareholder equity capital, the current value of the bonus pool and the current value of the personal bonds of the board members.

Further articles

Tomorrow, I’ll indicate other provisions concerning accounting, solvency, receivership and so on, and release a reference page.

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