Monday, March 18, 2013

Capital not a lost cause?

Admati and Hellwig (my review here) (and fellow travelers) may be having some effect! From today's WSJ "Heard on the Street":
There is growing talk among regulators, for example, of forcing banks to issue a minimum amount of long-term debt, cap the size of their short-term liabilities or restrict activities that can be conducted within regulated bank subsidiaries.

At the same time, regulators seem to be focusing more on the need to pre-emptively address potential systemic risks.

Any such moves could further constrain banks' ability to juice returns through leverage while also limiting lucrative activities that fall outside a traditional lending function. That could subdue earnings growth already hampered by the superlow interest-rate environment.

The danger isn't lost on banks themselves. A number of banking groups recently joined together in a public attempt to rebut notions of a big-bank borrowing subsidy.”
OK, 3 out of 4 ain't bad. Admati and Hellwig (and I) take a dim view of asset risk regulation and the chance that regulators have any hope of seeing bubbles emerge. But more capital, and more people understanding that leverage and TBTF is a subsidy to banks, so banks are forced to fight about it... that's progress.

7 comments:

  1. "But more capital, and more people understanding that leverage and TBTF is a subsidy to banks, so banks are forced to fight about it... that's progress."

    http://en.wikipedia.org/wiki/Capital_(economics)

    I believe you mean more equity. Both debt and equity are forms of financial capital (as opposed to real capital / capital goods).

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  2. Betteridge’s law: "Any headline which ends in a question mark can be answered by the word no."

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  3. Another chance to sell my plan.

    As a start the idea of "risk free assets should be abandoned. It is the central conceit of the Basel "risk based" capital requirements. The one thing we have learned is that all assets are risky, perhaps in inverse proportion to to their appearance of riskiness. Mortgages were supposed to be safe. Government bonds were supposed to be safe. Ha. Ha.

    Having dispensed with that bit of nonsense we should set a high minimum capital requirements for all banks. Something on the order of $1 on each $8 of assets. In addition to that big banks should be have more capital in proportion to their size.

    Without getting into the math too deeply, every bank in excess of a given size let us say, about the top 35 banks, should be required to have additional capital = ((ln total assets) - 18)/100. Thus JPMorgan Chase with $2.3 trillion would be required to carry 16.1% capital instead of 12.5%.

    Further the 35 largest banks would be required to have an equal amount of funding derive from long term subordinated debentures. Those instruments (~$375 billion for JPM-Chase) would attract a CDS market that would be a canary in the coal mine for them.

    The third step in my plan would be to license the retailers like Walmart and Kroger to run in-store bank branches, thus ensuring that there would be nation wide chains of banks to compete with the incumbents. The retail banks would be restricted from opening branches outside of their stores and from engaging in wholesale banking or capital market operations.

    The final change that I want is to recognize that the money-market funds are banks and require them to be capitalized like banks. Reserve fund proved that they can be a dramatic source of infection in the system. They should no longer be permitted to do that.

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  4. John,

    How about this idea:

    Banks must be fully funded like any regular company, strictly debt and equity, no deposits allowed. Equity could be publicly traded or privately held.

    Then, the only kind of accounts that are legally allowed to be used (by both individuals and companies) as a medium of exchange are money market mutual funds (only short term high grade debt allowed). When I buy something from you, my fund company transfers some of its shares to yours. MMMFs already offer check writing and debit card services, in fact.

    It seems to me that the assets of a bank (e.g. small personal and business loans) are among the *least* suitable to be combined with a system of demand deposits.

    Best,

    Gideon

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    Replies
    1. A couple of additional points:

      1) It seems crucial to me that all asset values can freely float. The first-come first-serve principle of banking is simply a price control, which as always leads to socially inefficient rent-seeking (waiting lines).

      2) A large number of transactions are combined with short term loans (credit), and some are done in-kind. I don't think there is any problem with either of these.

      3) But payments sometimes need to be fulfilled this instant. Of course this can always be done with pure money (currency/reserves). Perhaps though MMMF shares could be an alternative. Vendors could advertise with something like: "We accept as payment all MMMFs with a seal of approval by institution X".

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    2. Issues remain, of course. What happens if, for whatever reason, people become worried about MMMFs, their values drop, and people stop accepting them as forms of payment? For any other security this would not be a major cause for concern. But if MMMFs are a big part of the system of payments this could have serious consequences. This is what the recent financial crisis was all about, no?

      Because people have a desire for a medium of exchange there will be a surge in money demand. The Fed will have to accommodate this through a monetary expansion. Preferably they would only buy up treasury bonds in exchange for money, however there would be a temptation to buy up (short-term high-grade) private debt as well, to "restore confidence" in the MMMF market. I suppose we'd prefer it if Fed stays out of private debt markets (but isn't this how the ECB is/was set up?). Perhaps MMMFs (the ones used as medium of exchange) should only invest in T-Bills?

      This stuff isn't simple...

      Coincidentally, Tyler Cowen writes about MMMFs this morning:

      http://marginalrevolution.com/marginalrevolution/2013/03/it-cant-happen-here-cyprus-and-money-market-funds.html

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  5. A few points.

    1) For a long while I thought the answer was to cap the size of the TBTF banks, but Admati & Hellwig have persuaded me that more equity is a better solution. There is no way to prevent central banks from bailing out important, failing financial institutions in the middle of a crisis, but it's very hard to figure out ex ante what the right cut-off in size is for "importance." On the other hand, more equity does reduce the likelihood of insolvency and the need for bail-outs.

    2) Roger Myerson has suggested that bank equity be measured against bank liabilities, not assets. The idea is that liabilities are what need to be be paid and it's hard to pretend that they are something other than what they are (as risk-weighting does for assets). So far as I can tell, there is no good reason for using assets as the measure, it seems to be a historic artifact without substance. In any event, for non-financial corporations, we talk about "debt/equity" ratios and there doesn't seem to be any good reason to apply a different measure for banks.

    -Douglas Levene

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