The Exciting World of Bank Capital

Rarely do we agree with folk from the (Herbert) Hoover Institute, but we like what John Cochrane has to say in the Wall Street Journal:

The central problem, at the core of Anat Admati and Martin Hellwig's "The Bankers' New Clothes," is capital. In order to make $100 of loans, a typical bank borrows $97—from depositors, from money-market funds, from other banks, or from bondholders—and sells $3 of stock, its "capital." So if only 4% of the bank's loans fail, the shareholders are wiped out, and the bank cannot pay its debts. Worse, if there is a rumor that some loans are in trouble, creditors may "run," each trying to get his money out first, and force a needless bankruptcy. Think of Jimmy Stewart in "It's a Wonderful Life."

And:

The solution seems pretty obvious, no? Banks should fund their investments by selling a heck of a lot more stock and borrowing a heck of a lot less, especially in the form of run-prone short-term debt, as most other companies do. Far more value was lost in the 2000 tech bust, for instance, than in the subprime mortgages that sparked the 2008 crisis, but the tech bust did not cause a financial crisis. Why? Tech companies were funded by stocks, not short-term debt. 

OK — we've got a quibble here. Those tech companies weren't financed through the sale of stock. Instead, issuing stock was a way for them to cash in. But Cochrane is correct that the impact of the tech bust was not wide felt, as people who had no money became paper billionaires and then people with no money. It may have sucked to own Pets.com, but they didn't leave a trail of unpaid creditors the way Lehman Brothers has. 

Back to the story:

More capital and less debt would stabilize the financial system in many ways. If a bank wants to rebuild its ratio of capital to assets from 1% to 2% by selling assets, it has to sell half of its assets. Doing so can spark a fire sale, especially if all the other banks are doing the same thing. If the same bank wants to rebuild capital from 49% to 50% of assets, it only has to sell 2% of its assets. That bank will also have a far easier time issuing more stock, rather than selling assets, which is a better way to build equity in the first place.

The U.S. government has instead addressed the risks of banking crises by guaranteeing bank debt. Guaranteeing debts creates perverse incentives, so our government tries to regulate the banks from taking excessive risks: "OK, cousin Louie, I'll cosign the loan for your Las Vegas trip, but no poker this time, and be in bed by 10."

....  

Now pretty much all of the big banks' debt is guaranteed, explicitly or implicitly through the widely held expectation that a big bank's creditors will be bailed out. But our regulators promise that next time, trust them, they really will spot trouble ahead and do something to stop it—even though our massive bank-regulation machinery failed to notice that subprime mortgages might be a bit risky in 2006 and even though, as Ms. Admati and Mr. Hellwig note, Europe's regulators still consider Greek government bonds to be risk-free assets.

Not only that, but the implicit guarantee behind the too-big-too-fail banks means they have artificially low borrowing costs, which encourages more borrowing. We now switch you to a Bloomberg article.

Lately, economists have tried to pin down exactly how much the [implicit government guarantese] lowers big banks’ borrowing costs. In one relatively thorough effort, two researchers -- Kenichi Ueda of the International Monetary Fund and Beatrice Weder di Mauro of the University of Mainz -- put the number at about 0.8 percentage point. The discount applies to all their liabilities, including bonds and customer deposits. 

Small as it might sound, 0.8 percentage point makes a big difference. Multiplied by the total liabilities of the 10 largest U.S. banks by assets, it amounts to a taxpayer subsidy of $83 billion a year. To put the figure in perspective, it’s tantamount to the government giving the banks about 3 cents of every tax dollar collected. 

Let's try that one more time.

To put the figure in perspective, it’s tantamount to the government giving the banks about 3 cents of every tax dollar collected.  

The top five banks -- JPMorgan, Bank of America Corp., Citigroup Inc., Wells Fargo & Co. and Goldman Sachs Group Inc. - - account for $64 billion of the total subsidy, an amount roughly equal to their typical annual profits (see tables for data on individual banks). 

In other words, the banks occupying the commanding heights of the U.S. financial industry -- with almost $9 trillion in assets, more than half the size of the U.S. economy -- would just about break even in the absence of corporate welfare. In large part, the profits they report are essentially transfers from taxpayers to their shareholders. 

Let's do that one again, too.

In large part, the profits they report are essentially transfers from taxpayers to their shareholders. 

Enjoy that while you mull on the sequester.

Regulators can change the game by paring down the subsidy. One option is to make banks fund their activities with more equity from shareholders, a measure that would make them less likely to need bailouts (we recommend $1 of equity for each $5 of assets, far more than the 1-to-33 ratio that new global rules require). Another idea is to shock creditors out of complacency by making some of them take losses when banks run into trouble. 

Hold on — who is that magisterial "we" who recommends a 5:1 ratio?

It's the Bloomberg editors! Not Occupy Wall Street, not Michael Moore, but the editors of America's premier business magazine!

Hello! Is this thing on?

Now, there are a couple of ways out of this problem, which is good — because the banks are going to scream about implementing each one of them. With luck, they'll get hoarse.

First, and most directly would be to require banks to hold more capital. A second method would be to make debt less attractive. As discussed here, debt is deductible from taxes, while equity is not. This means there is a built-in tax preference for using debt (and getting all leveraged up.) Reducing (if not eliminating) the deductibility of debt would help level the playing the field, and make it less expensive for banks to add more capital.

For the third option, we turn to Kevin Drum at Mother Jones:

Split up the banks. If they're too big to fail, and everyone knows it, the only real answer is to make them small enough that they can fail. Creditors would then take care of all the rest.

Splitting up the banks would remove the implicit government guarantee associated with too-big-to-fail. The banks would be small enough to fail without jeopardizing the global financial system, and life would go on.

And that's what one senator proposed last year with the Safe, Accountable, Fair, and Efficient Banking Act of 2012.

Introduced by Senator Sherrod Brown on May 9, 2012, the following bill would place size and leverage limits on big banks.  Specifically it would:

• Impose a 10 percent cap on the share of U.S. deposits that any one bank could hold. This would eliminate loopholes in the existing federal deposit share cap
• Impose a 10 percent cap on the liabilities that any one financial company can take on, relative to the U.S. financial sector. Like the deposit concentration limit, this closes loopholes in existing law.
• Impose a limit on the non-deposit liabilities (including off-balance-sheet exposure) of a bank holding company of 2 percent of GDP.
• Impose a limit on the non-deposit liabilities (including off-balance-sheet exposure) of any non-bank financial institution of 3 percent of GDP.
• Codifies a 10 percent leverage limit for large bank holding companies and selected nonbank financial institutions into law. 

Under the measure, no bank holding company could exceed a size of $1.3 trillion in assets (at current GDP).  If enacted, Bank of America ($2.2 trillion as of 3/31/2012), JP Morgan Chase ($2.3 trillion),  Citigroup ($1.9 trillion), and Wells Fargo ($1.3 trillion) would all have to downsize.

Unfortunately, the bill was never referred out of sub-committee.