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| The Fed Scrutinizes Bank Capital, in the Popular Imagination |
The good news. The Fed wants more capital. Banks should absorb their own risks, rather than all of us to count on the Fed to stand over their shoulders and make sure they never lose money again.
Confusing language has long been a roadblock in this effort, along with red herrings passed along thoughtlessly.
"Costly"
The WSJ writes
The Federal Reserve plans to hit the biggest U.S. banks with a costly new requirementMr. Tarullo's testimony does not contain any mention of the idea that higher capital requirements will be "costly." My view, expressed nicely by Admanti and Hellwig's book, is that there is zero social cost to lots more bank equity. Disagree if you will, but source it please, don't just pass it on as if the source said it or as if this is a fact like the sun coming up tomorrow.
"Hold"
Here are three uses of "hold" in the WSJ article [my emphasis]
At issue is a requirement for the world's largest banks to hold an extra layer of financial padding in case of another crisis.
Last week, the Fed and other regulators adopted another set of rules that require banks to hold very safe assets they can sell for cash in a pinch.
Mr. Tarullo said Fed officials are working on a separate rule that would require all financial firms—not just banks—to hold a minimum amount of securities or other collateral
An unsophisticated reader could well be excused for thinking that "capital" is some special "asset" that the bank "holds" in reserve against losses. Banks "hold" loans, reserves at the Fed, gold coins in some Uncle-Scrooge vault, and this "capital," whatever that is.
No. Capital is where banks get money, not where they put it. It's a liability, not an asset. Capital has nothing to do with reserves, liquidity, safe assets or other "holdings."
No. Banks "issue" capital. They "retain" capital if you must. But banks simply do not "hold" capital, and let's stop saying so.
Alas, this isn't just the journal, as Mr. Tarullo himself mis-spoke
No. Capital is where banks get money, not where they put it. It's a liability, not an asset. Capital has nothing to do with reserves, liquidity, safe assets or other "holdings."
No. Banks "issue" capital. They "retain" capital if you must. But banks simply do not "hold" capital, and let's stop saying so.
Alas, this isn't just the journal, as Mr. Tarullo himself mis-spoke
By further increasing the amount of the most loss-absorbing form of capital that is required to be held by firms that potentially pose the greatest risk to financial stability, we intend to improve the resiliency of these firms,"Charge"
There are 20 instances in the WSJ article of the word "charge" or "surcharge," starting with
the regulator intends to impose a capital surcharge that will require the biggest U.S. banks to maintain fatter cushions to protect against potential losses.This is just as profoundly misleading. It sounds like the Fed is taxing the banks. Much as I would like a Pigouvian tax on short term debt, a capital requirement is nothing of the sort. Banks are not being "charged" a cent.
Alas, here too I can't fault the Journal too badly, as there are 14 instances of "charge" in Mr. Tarullo's testimony, starting with a section heading "GSIB risk-based capital surcharges." In turn, Mr. Tarullo is echoing the Basel committee's language.
We don't have to pass it on. We can say "additional capital requirement."
Bloomberg did a much better job (Byline just "editors" so I don't know who to praise here)
...Fed Governor Daniel Tarullo said that the central bank plans to subject systemically important banks to an added capital buffer significantly greater than what international rules require. The purpose of the so-called surcharge, which could be as much as several percent of risk-weighted assets, is to discourage complexity and fragility. It will be larger, for example, for banks that depend heavily on short-term funding of the kind that proved unreliable during the 2008 crisis."Subject to" and the nice "so-called surcharge" avoid the red herrings nicely. And putting short-term funding right up front is spot on.
The Fed, for example, is requiring that banks have extra capital to absorb the costs of operational failures,"Have" is better than "hold."
But best of all, Bloomberg goes right at the common fallacies and explains it all nicely.
The Fed's efforts to make big banks fund themselves with more capital should not be perceived as punishment. Capital, also known as equity, is money that banks can use to make loans or fund whatever activities they choose. Because it doesn't have to be paid back like debt, it makes them more resilient in times of crisis -- a feature that should be seen as an advantage.
Nonetheless, the biggest U.S. banks operate with astonishingly little capital. As of June 30, the six largest U.S. banks had an average of about $5 in tangible equity for each $100 in assets (by international accounting standards) -- far less than smaller banks and enough to absorb a loss of only 5 percent of assets. Executives prefer to rely heavily on debt for two main reasons: It's relatively cheap thanks to various taxpayer subsidies, and it makes banks' performance -- measured as the return on equity -- look better in good times.Aah, clarity at last. The article does not use "hold" or "held" once.
The PC left has a point: little words do matter.
It's relatively cheap thanks to various taxpayer subsidies
ReplyDeleteAah, clarity at last.
Auuggghhh. Banks get to deduct interest paid on debt in calculating taxable income - just like every other business in America. It is not a subsidy. Investors might be confident that the government will bail out banks if they default and that might reduce interest rates on bank debt, but the government has no obligation (beyond basic deposit insurance) and there is no subsidy.
Bank capital is expensive. Bank preferred shares are trading with a yield (paid from after tax income) of between 5 and 6% - in today's world, that is expensive money.
But banks are different in that they can arbitrage this subsidy -- and the far more important too big to fail subsidy -- in a way that regular businesses can't. No other business can borrow 97% of its funding, and stick the taxpayer with the bill if it goes sour.
DeleteIf you borrow $97 to buy $100 mortgage backed securities you do not get to deduct the interest. If you buy bank equity and the bank borrows $97 dollars to buy $100 mortgage backed securities you -- the owner of the bank -- do get to deduct the interest. And you pay a much lower rate because the government will pay the lenders if the MBS don't work out. Regular widget-making corporations can't exploit it that much.
If you borrow $97 to buy $100 mortgage backed securities you do not get to deduct the interest.
DeleteI believe that if I am making that trade as a "business" I do get to deduct the interest paid.
I have no problem with the proposition that a bank should have equity equal to somewhere between 5 and 10% of assets. To jump down to Frank's comment - subordinated debt is just "equity" with the tax advantages of debt. Since subordinated debt does not share in any upside growth it is more like a preferred share than a common share.
I think John's point is that no business can be so leveraged except for banks, i.e., regular widget-making companies cannot fund their operations by 97% debt and 3% equity.
DeleteMy understanding of the concept of subsidy is the fact that TBTF banks can borrow money at a cheaper price due to lower risk premium and the subsidy is the difference between this lower rate and the rate that non-TBTF banks have to pay.
Delete@Absolon: "Banks get to deduct interest paid on debt in calculating taxable income - just like every other business in America. It is not a subsidy."
DeleteAnd just like mortgage interest for homeowners. Because it's implemented widely, and as a tax deduction, does that mean it's not a "subsidy"? How about if we call it a "tax expenditure"? Whichever of those words you chose, it's arguably an economic distortion (compared to the counterfactual, a "free" market where interest is not privileged as a deductible expense).
To use John's benchmark here from para 7, those distortions arguably have a high "social cost."
Our long history of many interest expenses being tax-deductible seems to lead many to think of those deductions, unconsciously, as being "natural" in some sense. But they very much aren't. Would it be "natural" for credit-card interest for consumption purchases to be deductible?
@John Cochrane: "If you borrow $97 to buy $100 mortgage backed securities you do not get to deduct the interest."
I'm astounded that you make this statement and that Absalon doesn't know to correct you. Individual taxpayers can certainly deduct this interest, to the extent it's exceeded by income from financial investments (interest, dividends, short-term cap gains, but not long-term cap gains unless you forego the low tax rate on those long-term gains).
This another (IMO particularly egregious) example of (IMO) distortionary tax policy re: interest expenses.
Many, of many economic schools and political persuasions, think mortgage interest should not be deductible. I would like to suggest that no interest expenses should be deductible.
Steve,
Delete"Our long history of many interest expenses being tax-deductible seems to lead many to think of those deductions, unconsciously, as being "natural" in some sense. (compared to the counterfactual, a free market where interest is not privileged as a deductible expense)"
In a free market the government would not be responsible for enforcing contracts (debt or otherwise) agreed to by two parties, and there would be no taxation. But since we want a government to enforce private contracts, we must find a way to pay for those government officials (taxation) to write and apply laws to those contracts.
To say that a certain tax policy is distortionary / not distortionary misses the bigger picture - all tax policy is neither free market nor natural and hence "distortionary" - it exists to pay for a legal framework under which disputes between private individuals are resolved.
"In a free market the government would not be responsible for enforcing contracts"
DeleteMost definitions of 'free market' would include property rights. E.g., see http://www.econlib.org/library/Enc/FreeMarket.html
@Frank Restly: "To say that a certain tax policy is distortionary / not distortionary misses the bigger picture"
DeleteYes, also that the universe will end in heat death. But the smaller issue was one issue that was at issue here.
Steve,
Delete"I would like to suggest that no interest expenses should be deductible."
How does making interest expenses eliminate a distortion when it is my contention that all tax policy is distortionary?
The only way you get away from a legal system that is paid for in a non-distortionary manner is for both parties in a dispute to pay for a 3rd party to resolve the difference. That lends itself to the party with the highest bankroll being able to influence decisions in his / her own favor. Our legal system was founded on the principle of equal protection under the law (a decidedly non-market principle).
Anonymous,
Delete"Most definitions of 'free market' would include property rights. E.g., see http://www.econlib.org/library/Enc/FreeMarket.html"
I am not talking about property rights, I am talking about contract enforcement. Rothbard makes mention that slavery was a violation of property rights - a person has the right over his own body / person.
But he does not address indentured servitude - I owing a debt to another person must perform enough work to satisfy that debt. My debt to another person supersedes my right to my own person.
One of the more interesting passages:
ReplyDelete"In addition, the Federal Reserve has been working with the FDIC to develop a proposal that would require the U.S. GSIBs to maintain a minimum amount of long-term unsecured debt at the parent holding company level"
"The presence of a substantial tranche of long-term unsecured debt that is subject to bail-in during a resolution and is structurally subordinated to the firm's other creditors should reduce run risk by clarifying the position of those other creditors in an orderly liquidation process."
Not only will the Fed / FDIC require banks to use more long term debt, that long term debt will be subordinate to all other creditors. Wow.
As a firm, you typically want your tranches of debt to be short term subordinated to long term. Even well run companies can struggle at times, and so it is in a company's best interest to reward long term investors who stick it out in good times and bad. That added compensation usually consists of a higher annual interest payment but many times also includes a higher level claim during bankruptcy proceedings.
Great post, and interesting comments so far! I'm unclear on one point: if banks reap such big advantages from funding themselves mostly via debt rather than mostly via equity like other types of companies (that's true, right?), why don't other businesses do this more?
ReplyDeleteJohn, your answer was "banks are different in that they can arbitrage this subsidy," referring to the tax advantages of debt over equity. But I'm not clear on what this means. What do you mean by arbitrage here?
Do you mean that it's banks are only different because of TBTF? Is the story that everyone (creditors, i.e. other banks) know that the government will bail out big banks (and therefore creditors of the bank, i.e. other banks) if there are major losses, so they are willing to lend huge amounts to big banks but not small banks or, say, Walmart that wouldn't get bailouts? Or is there something else I'm missing that is special about (big) banks.
Bank runs cause enormous social costs (externalities, or whatever you want to call them). The evidence is abundant all over the world, the most clear example being the great depression. Everyone knows this, so everyone expects the govt. to subsidize if there is a run. If Walmart goes bankrupt it will be a big mess but that cannot cause a depression. Bailouts to companies other than banks are very rare.
DeleteI think it's useful to look at the hierarchy of money, a central concept in the thought of Perry Mehrling. The higher you are in this hierarchy, the less it costs you to borrow. At the top are the liabilities of important central banks. The U.S. pays very little interest on reserves, yet vast sums are deposited with the Fed. And the European Central Bank actually charges parking fees, meaning that you must pay *them* to keep your money as deposits. Securities issued by non-financial companies are at the bottom of the hierarchy of money.
DeleteProf. Cochrane has a paper where he examines the "convenience yield" available at the bottom end of the hierarchy, but this subject is generally outside the purview of asset pricing specialists, and we can gain a more useful analytical perspective from scholars who adopt the "money view". Banks are different than other companies in that they specialize in the production of convenience yield, and get more of it by taking deposits than by issuing equity. This seems to reflect a global shortage of such "convenience". In a follow-up blog to this one, Prof. Cochrane posts some scary graphs showing that the shortage is steadily getting worse over time.
If I remember correctly, Spanish banks held 14% equity, and I don't think that anywhere in EU except perhaps UK legal limit was below 8%. And they were OK until Greece crisis, that was more a political one (Eu banks were politically encouraged to loan money to Greece and other Euro lands, a politicians "guaranteed" that strict Eurozone rules were obeyed, hiding that Greece doctored books to get into Eurozone and did the same ever since).
ReplyDeleteIt's surprising that the WSJ would write such stuff, given that they carried a book review of Admati's and Hellwig's book exposing exactly these misconceptions.
ReplyDeletehttp://online.wsj.com/news/articles/SB10001424127887324048904578318064208389202
The author of that review was . . . . oh wait
This bit of the Bloomberg story is misleading, I think:
ReplyDelete"Capital, also known as equity, is money that banks can use to make loans or fund whatever activities they choose."
It suggests that the bank lends out the capital whereas the bank in fact needs to have that capital as a % of what it lends out to support it when loans aren't repaid.
I wrote the last post. Having done some more reading I at last understand bank capital, which is extremely simple but it's very hard to find a proper explanation. So the quote isn't misleading.
ReplyDeleteHere's what I wrote before:
This bit of the Bloomberg story is misleading, I think:
"Capital, also known as equity, is money that banks can use to make loans or fund whatever activities they choose."
It suggests that the bank lends out the capital whereas the bank in fact needs to have that capital as a % of what it lends out to support it when loans aren't repaid.