“Bank for International Settlements to allow banks to keep 1% of reserves in bitcoin,” cries the headline on an article about the BIS’ newly proposed regulations for banks holding crypto assets.
The article was retweeted by Changpeng "CZ" Zhao, CEO of crypto exchange Binance, with the comment, “Banks now use bitcoin for reserves. Probably nothing.” Crypto Twitter went wild. Zhao's comment was retweeted thousands of times and “liked” by more than 10,000 people.
If the BIS really intends to “extend its hand” to bitcoin by allowing banks to hold it as reserves, as the article claims, that would indeed be great news for bitcoin as an asset class, though perhaps not for those hoping it would eliminate banks. But sadly, the BIS, which is an organization of the world's major central banks, has no intention of doing any such thing. The article unfortunately misunderstands the BIS’ proposals. Far from extending a helping hand to bitcoin, the BIS is cutting the rope.
Frances Coppola, a CoinDesk columnist, is a freelance writer and speaker on banking, finance and economics. Her book “The Case for People’s Quantitative Easing” explains how modern money creation and quantitative easing work, and advocates “helicopter money” to help economies out of recession.
The BIS proposes that banks’ total exposure to all cryptocurrencies (not just bitcoin) and most stablecoins should be no more than 1% of their Tier 1 capital. But Tier 1 capital is not reserves. And that is a restriction, not a permission.
Bank reserves are a type of electronic cash issued by central banks and used by licensed banks to make payments. Solvent banks have more assets than they have deposits, but only a fraction of those assets are in the form of bank reserves. This is where the term “fractionally reserved” comes from. It doesn't mean the bank’s balance sheet doesn’t balance. It refers to the fact that the business of commercial banks is to earn profits by exchanging borrowed liquid assets (deposits) for higher-yielding illiquid assets (loans).
Because only a fraction of the bank’s assets can be used to settle deposit withdrawals, banks are always at risk of a bank run, which is when customers all demand their deposits back at the same time. In a typical bank run, the bank sells its illiquid assets at a heavy discount to obtain the reserves it needs to repay its customers. We call that a “fire sale.” Eventually, it runs out of assets to sell and is forced to shut its doors.
To limit the likelihood of bank runs and fire sales, regulators force licensed banks to hold a certain proportion of their balance sheets in the form of liquid assets. Traditionally, in the U.S., banks had to hold sufficient bank reserves to back at least 10% of eligible deposits – this was known as the “reserve requirement.” But the Federal Reserve abolished the reserve requirement in March 2020. It was replaced by the BIS’ "liquidity coverage ratio" (LCR), which forces banks to keep sufficient high-quality liquid assets to meet all known and anticipated payment requests over a 30-day period.
High-quality liquid assets
High-quality liquid assets include bank reserves and other assets that can be readily exchanged for bank reserves, such as U.S. Treasury bills. The assets don't include cryptocurrencies. Nothing in the BIS’ proposal changes that. Banks don't use bitcoin for reserves, and if the BIS’ proposal is adopted by regulators, they never will.
But if Tier 1 capital isn’t reserves, what is it? Well, it can be regarded as a cushion that protects depositors from losses if the bank fails.
When a bank fails, the total realizable value of its assets is typically less than the total value of its liabilities and equity. So not everyone is going to get their money back. Claims against the bank’s remaining assets are therefore settled in a strict order based on the ranking of the claim.
Secured claims (borrowing against which the bank has pledged collateral) and any “super-senior” claims are paid first. Depositors and senior bondholders, who are unsecured creditors of the bank, are next. Then, if there is anything left, holders of junior (“subordinated”) debt get paid. At the bottom of the pile are shareholders, who usually get nothing.
It should be obvious that if depositors are to get their money back, there must be enough shareholder equity and junior debt to absorb any losses. This is what is known as bank “capital.” Bank capital is divided into three categories: Common Equity Tier 1 (CET1) capital, which approximates to shareholders’ funds; Additional Tier 1 (AT1) capital, which is typically debt convertible to equity; and Tier 2 capital, which is a broader category of subordinated debt. CET1 capital is first in line for losses if a bank files for Chapter 11 bankruptcy, followed by AT1. Tier 2 is usually affected only if the bank goes into liquidation.
The capital ratios reported by banks are the ratios of CET1, Tier 1 and total capital to total assets weighted for risk. The “leverage ratio” introduced after the 2008 financial crisis is the ratio of Tier 1 capital to unweighted total assets. Here, for example, is how J.P. Morgan & Chase reported its capital and leverage ratios in the first quarter:
(The ”supplementary leverage ratio” (SLR) is a U.S. specific version of the BIS Tier 1 leverage ratio.)
The basic BIS capital requirements specify that banks must have a minimum total capital of 8% of risk-weighted assets, of which 6% must be Tier 1. National regulators, however, usually have more stringent requirements, particularly for the biggest banks – the ones that are “too big to fail." After all, no one wants the government to have to bail out big banks again like it did in 2008. So in the example above, J.P Morgan has much higher Tier 1 and total capital ratios than the BIS minimum.
Now that we have clarified the difference between Tier 1 capital and reserves, let’s look at that BIS proposal for crypto assets again. The BIS provides a handy chart showing how it has divided crypto assets into two groups, each with two subgroups, and assigned different capital requirements to each group:
Group 1 is tokenized traditional assets and stablecoins that meet narrow criteria for stability and redeemability. Group 2 is everything else. Group 2 is deemed to be riskier than Group 1 and is therefore subject to much more stringent regulations.
All cryptocurrencies, including bitcoin, are in Group 2. So are most stablecoins.
The 1% exposure limit applies only to Group 2 assets. It means that because Group 2 assets are extremely risky, banks won't be allowed to have much in the way of exposure to them. In the example above, J.P. Morgan has Tier 1 capital of 13.7% of total risk-weighted assets. So for J.P. Morgan, total Group 2 crypto asset holdings (including bitcoin) can’t be more than 0.137% of its total risk-weighted assets – and considerably less of its total assets unweighted for risk. Admittedly, for a bank the size of J.P. Morgan, that is still a lot of bitcoin. But it’s worth remembering that the previous version of the BIS proposals, issued in June 2021, didn’t impose a total exposure limit. So, far from encouraging banks to hold bitcoin, the revised proposals actually make it more difficult.
In fact the BIS’ proposals make it extremely expensive for banks to hold or trade bitcoin on their own account at all. The regulations for Group 2a and 2b assets in the chart above force banks to write off bitcoin holdings fully against capital. The BIS’ 2021 proposals explain that the 1,250% risk weighting for Group 2b assets is effectively a 100% capital charge: “A $100 exposure would give rise to risk weighted assets of $1,250, which when multiplied by the minimum capital requirement of 8% results in a minimum capital requirement of $100 (i.e. the same value of the original exposure, as 12.5 is reciprocal of 0.08).”
For Group 2a assets, positions can be netted and the effect of hedging taken into account before the capital charge is applied. But for Group 2b, any hedging must be ignored and the capital charge applied to the larger of total gross long and short positions.
In layman’s terms, this means that banks cannot use customer deposits or issue senior bonds to finance the acquisition of bitcoin or any other cryptocurrency. They can finance them only from capital. That ensures that in the event of the value of their crypto holdings crashing to zero, none of their customers or creditors will be affected. But equity finance is considerably more expensive than debt finance – and shareholders might look askance at a bank taking such risks with their funds.
These regulations, if adopted, will apply only to banks holding and trading cryptocurrencies and private stablecoins on their own account. They won’t prevent banks providing crypto custody and trading services for their customers. And they won’t prevent banks from issuing their own tokenized assets and stablecoins. In fact, because these could meet the criteria for Group 1 assets, the proposals arguably encourage the banks to do so.
A place for CBDCs
And the elephant in the room are crypto assets issued by central banks called central bank digital currencies (CBDCs), which are completely excluded from this framework. BIS’ proposals don’t allow banks to use bitcoin as part of reserves. But CBDCs could potentially extend or replace reserves. And because they would be issued by the central bank, the BIS’ draconian capital requirements wouldn't apply to them. So not only do these proposals make holding bitcoin decidedly unattractive for banks, they set the stage for the entry of CBDCs to the crypto world.