If average bank capital in 2008 had been, say, 20 or even 30 per cent of assets (instead of the recent levels of 10 to 11 per cent), serial debt default contagion would arguably never have been triggered. Had Bear Stearns and Lehman Brothers continued as capital-conscious partnerships, a paradigm under which both thrived, they would probably still be in business. The objection to a capital requirement of 20 per cent or more, even when phased in over a series of years, is that it will suppress bank earnings and lending. History, however, suggests otherwise.20 to 30 percent used to be the sort of thing one could not say in public without being branded some sort of nut.
Alan also echoes the main point. Banks need lots of regulators micromanaging their investment decisions, because taxpayers pick up the bag for their too-high debts. Banks with lots of capital do not need asset micro-regulation:
...An important collateral pay-off for higher equity in the years ahead could be a significant reduction in bank supervision and regulation.A double bravo.
Lawmakers and regulators, given elevated capital buffers, need to be far less concerned about the quality of the banks’ loan and securities portfolios since any losses would be absorbed by shareholders, not taxpayers. This would enable the Dodd-Frank Act on financial regulation of 2010 to be shelved, ending its potential to distort the markets — a potential seen in the recent decline in market liquidity and flexibility.
However, to be honest, I have to nitpick a bit on what seems like the right answer for some of the wrong reasons.
Alan seems to argue that the rate of return to equity is independent of leverage:
Banks compete for equity capital against all other businesses....
In the wake of banking crises over the decades, rates of return on bank equity dipped but soon returned to their narrow range. ...
What makes the stability of banks’ rate of return since 1870 especially striking is the fact that the ratio of equity capital to assets was undergoing a significant contraction followed by a modest recovery. Bank equity as a percentage of assets, for example, declined from 36 per cent in 1870 to 7 per cent in 1950..Since then, the ratio has drifted up to today’s 11 per cent.
So if history is any guide, a gradual rise in regulatory capital requirements as a percentage of assets (in the context of a continued stable rate of return on equity capital) will not suppress phased-in earnings..There is an exam question in here: what seems wrong? Answer: Competition for equity capital should drive the risk adjusted rate of return for bank equity to be the same as for other businesses. If banks issue more capital, the raw rate of return to equity should decline. So should the variability (beta, risk) of that return. (Other things held constant, which may well be why the historical record is muddy.)
In fact, Alan seems precisely to be making the banks' argument. They claim that the return on equity capital is independent of leverage. They have to pay (say) 10% to shareholders, but only 1% to debt holders, so debt is a cheaper source of financing. Banks claim that forcing them to issue more expensive capital will force them to raise loan rates and strangle lending. Which, curiously, Alan seems to be endorsing. Though he starts with
The objection to a capital requirement of 20 per cent or more, even when phased in over a series of years, is that it will suppress bank earnings and lending. History, however, suggests otherwise.He follows up with
...bank net income as a percentage of assets will be competitively pressed higher, as it has been in the past, just enough to offset the costs of higher equity requirements. Loan-to-deposit interest rate spreads will widen and/or non-interest earnings will increase.Ok, so earnings may not be affected, but a rise in loan-to-deposit spreads is exactly what the banks are warning of, and it's hard to see how that would not "suppress bank lending."
All this only happens if investors demand the same return to equity no matter what leverage, and competition then forces banks to deliver that return. This proposition is precisely what advocates (such as myself) or more capital deny. Investors are not that dumb, they demand a competitive risk adjusted rate of return. More capitalized banks will deliver lower rates of return -- and equally lower risk. Bank "stock" will look very much like long term bonds and become the cornerstone of safe portfolios. So we get all of Greenspan's benefits and none of the downside.
Of course, this is just an editorial. He may have meant "risk adjusted" return, and was trying to simplify language.
"Investors are not that dumb, they demand a competitive risk adjusted rate of return. More capitalized banks will deliver lower rates of return -- and equally lower risk."
ReplyDeleteHow do these observations square with the leverage and volatility anomalies in asset pricing?
High volatility and high leverage stocks have low returns. Investors earn higher returns on low volatility and low leverage stocks.
By lowering leverage and volatility the banks would be increasing their cost of capital.
Of course, it's possible that a loading to some risk factor could be negatively correlated with leverage and volatility, but that does not sound plausible. And if that's the case, then why focus on capital?
An alternative explanation could be that investors are indeed 'that dumb', but that also doesn't seem satisfying.
Any ideas?
I agree and I continue to pump for escalating capital requirements on bigger banks. I also want to see the biggest banks issue tradeable subordinated debt in large quantities so that a market in default swaps on that debt can be maintained.
ReplyDeleteIs this basically a MM argument? Financing the whole enterprise should cost the same regardless of mix.
ReplyDeleteThe most obvious MM failure here, though, seems to be the value of the of the taxpayer funded put. So, lending might be strangled by the reduction of that subsidy.
Yes, that's a good reason why MM does not hold privately, though it still holds socially. All your extra lending comes from a taxpayer subsidy. If subsidizing (more) debt is a good idea, let's just do it the old fashioned way, on budget. Send everyone who borrows a dollar an extra ten cents. Ridiculous regressive idea? Indeed. So let's not hide it in bank bailout guarantees!
DeleteIf MM held socially, then existing patterns of bank funding could be explained entirely as a result of the implicit bailout guarantee. But we know that the convenience yield on short-term bank debt is important. Stulz and DeAngelo highlight this point in their paper explaining bank leverage ratios. And this yield is also earned by shadow banks (which you would like to ban).
DeleteYou understand convenience yield well enough - having authored a paper on it - but asset pricing guys treat it as an anomaly, while it is a central phenomenon in banking. This is why I don't expect the most insight into bank funding to come from the asset pricing perspective. When Perry Mehrling explains why he adopted the "money view" to understand banking, it makes me wonder why more people haven't followed, especially if they want to propose useful reforms to the monetary system.
One useful concept from Mehrling is to compare banks with securities dealers (who don't need much equity funding). We could get more lending by bringing banks closer to a matched book. Higher equity requirements are one way to do that, but since this proposal is not based on the money view, it completely overlooks the importance of convenience yield.
I also frequently hear bank CEOs refer to implicit assets that accompany deposit liabilities. They seem to view a relationship between revenues per customer and their deposit base, in addition to the cash stock of the deposits. If this is true, then wouldn't Modigliani-Miller fail to account for the reduced deposit revenues per equity dollar in the current business model? FDIC insurance + TBTF subsidy (which seems to wax during periods of stress) + implicit relationship oriented assets could justify unexpectedly higher equity returns in the face of lower leverage.
DeleteFranco,
Delete"Is this basically a MM argument? Financing the whole enterprise should cost the same regardless of mix. The most obvious MM failure here, though, seems to be the value of the of the taxpayer funded put. So, lending might be strangled by the reduction of that subsidy."
The failure in MM here is how a bank (or any other company) is able to value it's own liabilities (debt versus equity). A bank must use the market value of it's equity to determine it's ratio of equity to assets. A bank can use the par (not market) value of it's debt to determine it's ratio of debt to assets.
This is why when Greenspan says that bank capital should be 20% to 30% of assets, I do not believe he is referring to an equity to assets ratio. Because the value of a bank's equity is market determined and because the value of a bank's assets is market determined, it is next to impossible for a bank of it's own accord to hit a predetermined ratio of equity to assets.
I'm a bit afraid that the higher Capital less regulation argument will turn out to raising Capital in the beginning then deregulating and at a later point decreasing the capital needed.
ReplyDeleteSo you be left of with just less regulation.
And even with higher capital requierments you are still in a too big to fail situation. And a lot of regulation/micormanagmenet is needed.
Josef - this was certainly Mark Thoma's take on Greenspan's oped. Mark is for more capital but not so sure it means Dodd-Frank should be shelved.
DeleteYes, simpler the better for regs. Banks should lend capital.
ReplyDeleteA couple of questions: there was a time in which some banks in the thrift industry were owned by depositors---building & loans I think were set up this way, some old S&L's too. Is this a good business model?
Another q: if the US went to 100% equity-financed lending, what would banks do with depositor money? Who would want deposits?
Benjamin,
Delete"Another q: if the US went to 100% equity-financed lending, what would banks do with depositor money? Who would want deposits?"
Presumably, depositors would in essence become equity shareholders in banks. This is not really addressed by Greenspan (or Cochrane) but in such a situation, are depositor class shareholders also voting shareholders?
If I am a depositor in a bank and told that I will no longer enjoy deposit insurance, the first thing that I would demand is that my deposits represent a voting stake in the bank.
From Greenspan,
ReplyDelete"If average bank capital in 2008 had been, say, 20 or even 30 per cent of assets (instead of the recent levels of 10 to 11 per cent), serial debt default contagion would arguably never have been triggered."
A bank (or any other company) is going to have an impossible time trying to match the market value of it's equity with the market value of it's assets under management. I have made this point before.
If the market value of a bank's debt rises, the bank does not see an increase in it's liability. Therefor, a bank is able to hit a debt to equity ratio simply by conversion.
And so, why does Greenspan recommend a capital to assets ratio (20 to 30 percent) instead of a debt to equity ratio?
I do not understand why anyone is still giving Greenspan a platform.
ReplyDeleteHe should have come to the view that higher capital would make the banks safer twenty years ago - that might have been useful.
Probably best to just focus on what Greenspan said, and what is being discussed, than what he should've said 20 years ago.
ReplyDeleteHis point is:
1) The risks and incentives of banking were misaligned in 2008
2) Regulation can address this misalignment, though such regulations are distortionary
3) Higher capital requirements are an equally effective but less distortionary alternative to regulations in addressing the misalignment
"Probably best to just focus on what Greenspan said"
DeleteNo - the point is that for me Greenspan does not have the credibility for me to invest the time and energy into deciding whether, after a life time of being wrong, he is right this time.
There are too many people who think that they have a right to be taken seriously. Greenspan is one of them.
Flashback to the mid 1980s when Mr. Greenspan backed the argument of "money center" banks that Glass Steagall was obsolete due to the newfound science of risk management. By advocating 20% capital (and more?), this looks like a backdoor way of re-establishing Glass Steagall. We will be back to classical banking (I've always seen the Paul Volcker's thrust as such) --- taking deposits to lend to businesses (and keep it on the bank's balance sheet). And those will be the only activities that FDIC will insure and that the Fed will be prepared to bail out.
ReplyDeleteBanks as utilities with utility like returns. This is what the commercial bank license and franchise of the future is beginning to look like.