Kevin Warsh has a nice WSJ oped warning of financial problems to come. The major point of this essay: "countercyclical capital buffers" are another bright regulatory idea of the 2010s that now has fallen flat.
As in previous posts, a lot of banks have lost asset value equal or greater than their entire equity due to plain vanilla interest rate risk. The ones that haven't run are now staying afloat only because you and me keep our deposits there at ridiculously low interest rates. Commercial real estate may be next. Perhaps I'm over-influenced by the zombie-apocalypse goings on in San Francisco -- $755 million default on the Hilton and Parc 55, $558 million default on the whole Westfield mall after Nordstrom departed and on and on. How much of this debt is parked in regional banks? I would have assumed that the Fed's regulatory army could see something so obvious coming, but since they completely missed plain vanilla interest rate risk, and the fact that you don't have to stand in line any more to run on your bank, who knows?
So, banks are at risk; the Fed now knows it, and is reportedly worried that more interest rates to lower inflation will cause more problems. To some extent that's a feature not a bug -- the whole theory behind the Fed lowering inflation is that higher interest rates "cool economic activity," i.e. make banks hesitant to lend, people lose their jobs, and through the Phillips curve (?) inflation comes down. But the Fed wants a minor contraction, not full-on 2008. (That did bring inflation down though!)
I don't agree with all of Kevin's essay, but I always cherry pick wisdom where I find it, and there is plenty. On what to do:
Ms. Yellen and the other policy makers on the Financial Stability Oversight Council should take immediate action to mitigate these risks. They should promote the private recapitalization of small and midsize banks so they survive and thrive.
Yes! But. I'm a capital hawk -- my answer is always "more." But we shouldn't be here in the first place.
Repeating a complaint I've been making for a while, everything since the great treasury market bailout of March 2020 reveals how utterly broken the premises and promises of post-2008 financial regulation are. One of the most popular ideas was "countercyclical capital buffers." A nice explainer from Kaitlyn Hoevelmann at the St. Louis Fed (picked because it came up first on a Google search),
"A countercyclical capital buffer would raise banks’ capital requirements during economic expansions, with banks required to maintain a higher capital-to-asset ratio when the economy is performing well and loan volumes are growing rapidly. "
Well, that makes sense, doesn't it? Buy insurance on a clear day, not when the forest fire is half a mile upwind.
More deeply, remember "capital" is not "reserves" or "liquid assets." "Capital" is one way banks have of getting money, by selling stock, rather than selling bonds or taking deposits. (There is lots of confusion on this point. If someone says "hold" capital that's a sign of confusion.) It has the unique advantage that equity holders can't run to get their money out at any time. In bad times, the stock price goes down and there's nothing they can do about it. But also obviously, it's a lot easier to sell bank stock for a high price in good times than it is just after it has been revealed that the bank has lost a huge amount of money, i.e. like now.
Why don't banks naturally issue more equity in good times? Well, because buying insurance is expensive, and most of all there is no deposit insurance or too big to fail guarantee subsidizing stock. So banks always leverage as much as they can. Behavioralists will add that bankers get over enthusiastic and happy to take risks in good times. Why don't regulators demand more capital in good times, so banks are ready for the bad times ahead? That's the natural idea of "countercyclical capital buffers." And after 2008, all worthy opinion said regulators should do that. Only some cynical types like me opined that the regulators will be just as human, just as behavioral, just as procyclically risk averse, just as prey to political pressures in the future as they were in the past.
And so it has turned out. Despite 15 years of writing about procyclical capital, of "managing the credit cycle," here we are again -- no great amounts of capital issued in the good times, and now we want banks to do it when they're already in trouble, and anyone buying bank stock will be providing money that first of all goes to bail out depositors and other debt holders. As the ship is sinking, go on amazon to buy lifeboats. Just as in 2008, regulators will be demanding capital in bad times, after the horse has left the barn. So, the answer has to be, more capital always!
Kevin has more good points:
Bank regulators have long looked askance at capital from asset managers and private equity firms, among others. But this is no time for luxury beliefs.
Capital is capital, even from disparaged sources.
Policy makers should also green-light consolidation among small, midsize and even larger regional banks. I recognize concerns about market power. But the largest banks have already secured a privileged position with their “too big to fail” status. Hundreds of banks need larger, stronger franchises to compete against them, especially in an uncertain economy. Banks need prompt regulatory approval to be confident that proposed mergers will close. Better to allow bank mergers before weak institutions approach the clutches of the Federal Deposit Insurance Corp.’s resolution process. Voluntary mergers at market prices are preferable to rushed government auctions that involve large taxpayer losses and destruction of significant franchise value.
It is a bit funny to see the Administration against all mergers, and then when a bank fails, Chase gets to swallow up failing banks with government sweeteners. Big is bad is another luxury belief.
Yes, banks are uncompetitive. Look at the interest on your deposits (mine, Chase, 0.01%) and you'll see it just as clearly as you can see lack of competition in a medical bill. But most of that competition comes from regulation, not evil behavior. As per Kevin:
The past decade’s regulatory policies have undermined competition and weakened resiliency in the banking business.
A final nice point:
The Fed’s flawed inflation forecasts in the past couple of years are a lesson in risk management. Policy makers shouldn’t bet all their chips on hopes for low prices or anything else. Better to evaluate the likely costs if the forecast turns out to be wrong.
Maybe the lesson of the massive failure to forecast inflation is that inflation is just bloody hard to forecast. Rather than spend a lot of effort improving the forecast, spend effort recognizing the uncertainty of any forecast, and being ready to react to contingencies as they arise. (I'm repeating myself, but that's the blogger's prerogative.)
"A countercyclical capital buffer would raise banks’ capital requirements during economic expansions, with banks required to maintain a higher capital-to-asset ratio when the economy is performing well and loan volumes are growing rapidly." -- Kaitlyn Hoevelmann at the St. Louis Fed.
ReplyDeleteA constant loan-to-capital ratio stipulation would have the same effect. Let R equal the maximum loan-to-capital ratio a private lending bank must not exceed at any time during the reporting period. As the economy expands and the lending bank makes loans to its customers (commercial, industrial or residential) its loan-to-capital ratio increases. When that ratio hits R, the lending bank must either (i) curtail lending activities, or (ii) raise additional regulatory capital if it wishes to increase loans on its books of account.
If R is a fixed number, then as the economy grows, bank regulatory capital must increase more or less in lock-step. Regulatory capital is permanent capital – i.e., it meets John's criterion as "capital", but need not be "common stock" capital. Long-term 'bonds' and medium-term 'notes' are forms of permanent capital. As the bonds and notes mature, the lending bank has the option to reissue the notes and bonds, or float new bond or note issues in the capital markets, or float new equity issues (common and preferred stock).
See M. H. Miller (1977), "Debt and Taxes", J. of Finance, 32, pp. 261-275, for example. M. H. Miller argues, in "Debt and Taxes", that "even in a world in which interest payments are fully deductible in computing corporate income taxes, the value of the firm, in equilibrium will still be independent of its capital structure." The premises for this assertion were first set forth in F. Modigliani and M. H. Miller, "The Cost of Capital, Corporation Finance and the Theory of Investment", Am. Econ. Review, Vol. 48, No.3, (June 1958), pp. 261-97.
Regulatory capital levels are all set as ratios. Capital to Risk-Weighted Assets, with different categories of capital (tier 1, TCE etc.) getting different expected levels.
DeleteMy remarks were in response to the remarks of Kaitlyn Hoevelmann at the St. Louis Fed. which John quoted in his blog article above.
DeleteWe could increase competition in the retail banking market by allowing retail chains like Walmart, Target, and Kroger to own banks that would operate inside their stores. The unions fought very hard to block Walmart from acquiring a kind of finance company called an industrial bank a few years ago. For their pains they got an even bigger monster called Amazon. Do you think they have learned anything? I don't think so either.
ReplyDelete"As in previous posts, a lot of banks have lost asset value equal or greater than their entire equity due to plain vanilla interest rate risk."
ReplyDeleteAnd they can manage that interest rate risk by selling certificates of deposit (same as they have always done).
"Capital is one way banks have of getting money, by selling stock, rather than selling bonds or taking deposits."
"Policy makers should also green-light consolidation among small, midsize and even larger regional banks. I recognize concerns about market power."
Equity (capital) cushion can come from one of two places.
Sold by large consolidated banks with an emphasis on consolidated market power or sold by the Treasury department with a de-emphasis on consolidated market power.
This:
https://musingsandrumblings.blogspot.com/2019/09/the-case-for-equity-sold-by-u.html
"Policy makers should also green-light consolidation among small, midsize and even larger regional banks. I recognize concerns about market power. But the largest banks have already secured a privileged position with their too big to fail status."
ReplyDeleteWell shit John, if that's the Kevin Warsh led consensus, then just have the Federal Reserve allow direct individual accounts (savings and checking) and go from a bunch of regional and larger banks to one singular bank (The Fed).
Can't get any more consolidated than that.
any word about the $9 Trillion the FED has printed to RESCUE Wall Street Bonuses?
ReplyDeleteA most insightful and learned message. I forwarded it to many friends. Thanks for sending it John. VH
ReplyDeleteSuperb, John. As you have repeatedly said, why doesn't the Fed run the cost/benefit of asset side of balance sheet regulation (Dodd Frank) against the perceived "expensive" cost of issuing more equity. It is indeed crazy that bankers are able to gamble with depositors money to achieve a higher ROE, all backed by the now explicit government bailout in failure scenarios.
ReplyDeleteI'm not remotely an expert in this area, but I thought Calomiris & Haber, Fragile by Design: The Political Origins of Banking Crises and Scarce Credit (2014) was a extremely interesting comparison of the banking systems of the US, Canada and Mexico. From the blurb "The United States has had twelve systemic banking crises since 1840, while Canada has had none."
ReplyDeleteCanada had, during 2007-8, its "ACB crisis". The banks in Canada basically batted it down by refusing to honor their obligations to the holders of ACB securities that the holders of ACB had purchased from the banks. The banks in question are: BNS, BMO, CM, TD, and RBC.
DeleteBanking in Canada, nonetheless, has its risks, of which the "stranded asset" risk is one which is large enough to cause concern of a magnitude such that the federal government modifies its GHG-regulations to work around it.
Every time a bank uses the discount window, some of the money should go into permanent capital and the FDIC gets a slice of the equity. Also much higher Deposit Gties are in order.
ReplyDeleteOne factor in 2008 that gets little attention is the introduction of new M2M accounting rules in the fall of 2007. The Fed isn't the only source of regulatory pressure.
ReplyDeleteRe: "The ones that haven't run are now staying afloat only because you and me keep our deposits there at ridiculously low interest rates."
ReplyDeleteSavers never transfer their savings outside the banks unless they are hoarding currency or convert to other National currencies. The source of monetary savings is demand deposits, directly or indirectly via the currency route (never more than a short-term situation), or through the banks undivided profits accounts.
Just one comment on banks M&A. If the equity of the bank is effectively negative (driven by interest rate risk but also, perhaps crucially in this case, bad loans especially in commercial real estate), I think no one will be willing to buy that bank (not even for a price of $0). And merging two unviable banks doesn't add up to a viable bank. This suggests that this process will have to be ultimately mediated via bankruptcy process and/or FDIC.
ReplyDeleteThe prose for this post was an absolute joy to read. Whatever you're doing, keep doing it!
ReplyDelete