Bank capital's moment of truth [Update]

The NY Times' Joe Nocera ran an interesting column touting the virtues of bank capital.

What made the column fascinating is how it highlighted how little would be accomplished by raising bank capital requirements.  This is particularly true when compared to the alternative of providing market participants with access to current asset and liability-level data in an appropriate, timely manner.

Capital matters. Let me put that another way. The current fight over additional capital requirements for the banking industry, eye-glazing though it is, also happens to be the most important reform moment since the financial crisis broke out three years ago. More important than the wrangling over Dodd-Frank. More important than the ongoing effort to regulate derivatives. More important even than the jousting over the new Consumer Financial Protection Bureau.

Actually, requiring banks to disclose their current asset and liability-level data in an appropriate, timely manner would be the most important reform.  The fight over additional capital requirements is simply so that regulators can say they did something, even if this something is knowably of de minimus value.

As previously discussed on this blog, bank capital does not answer the question of who is solvent and who is not solvent.  Until that question can be answered, the financial system is prone to instability and taxpayers are on the hook for bailing out the banks.

The importance of being able to answer the solvency question cannot be over-stated.  The Financial Crisis Inquiry Commission determined that the interbank loan market froze because banks could not determine who was solvent and who was not.

Is the interbank loan market about to freeze in Europe again?  The Telegraph reported that Barclays and Standard Charter are reducing their unsecured loans to the eurozone banks because they are concerned with the solvency of these banks.

If investment banks like Merrill Lynch had had adequate capital requirements, they would not have been able to pile on so much disastrous debt.

Actually, higher capital requirements may in fact have made the situation worse.

With a higher capital requirement, Merrill would have been forced to hold fewer assets.  However, it is entirely possible that to offset the decline in income from holding fewer assets, Merrill would have changed the composition of its assets by shedding low risk securities, like government bonds, and holding much more of the disastrous debt in an attempt to generate a higher return on capital.

Merrill would have been able to do this because the individual assets on its balance sheet are hidden from the marketplace.

... If the big banks had not been able to so easily game their capital requirements, they might not have needed taxpayer bailouts.

Again, there is no direct connection between the ability to easily game the capital requirements and the need for a taxpayer bailout.  In fact, these two are not linked.

A bank can be gaming the capital requirements, aren't they all, and still be solvent and not in need of a taxpayer bailout.

A real capital cushion would have allowed the banks to absorb the losses instead of the taxpayers. That’s the role capital serves.

This is true in theory.  However, until banks are required to disclose their current asset and liability-level data, it is not true in practice.

The practical reason for bailing out the banks is the interconnectedness of the financial system.  Increasing bank capital to 20% of risk adjusted assets does not guarantee that the financial system will not collapse from contagion.  Without this guarantee, no government will gamble on the system not collapsing.

As this blog has discussed repeatedly, with disclosure of financial institution's current asset and liability-level data, it becomes possible to use bank capital to absorb losses and not bailout the banks.

Each bank has an incentive to use its competitors' data to determine the price and amount of its exposure to its competitors.  This exposure to its competitors will also reflect the bank's capacity to absorb losses.

In short, Jamie Dimon is not going to bet JP Morgan's existence on his dumbest competitor.

Adequate capital hides a plethora of sins. And because, by definition, it forces banks to use less debt, it can also prevent sins from being committed in the first place.

No. No. No.  Lack of disclosure hides a plethora of sins.  It is disclosure that prevents sins from being committed in the first place.

Regular readers of this blog know that with current asset and liability-level disclosure would come market discipline.

It is market discipline that prevents banks from taking on too much risk.  With market discipline, if a bank increases its risk profile, it can be expected to incur a higher cost of capital.  It is a fundamental principle of finance that investors need a higher rate of return when risk increases.  As the risk of insolvency increases, so will the return required by investors.  This will be reflected in a lower stock price.  Bank management, unless it is populated by boneheads, tends to be sensitive to the bank's stock price.

“There is no credible way to get rid of bailouts except with capital,” says Anat Admati, a finance professor at Stanford Business School and a leading voice for higher capital requirements.

Actually, there is a much more credible way to get rid of bailouts.  That way would be to combine current asset and liability-level disclosure with a simple solvency rule.

Financial markets are very good at valuing all the assets (loans and securities) and liabilities on a bank's balance sheet.  However, they can only do so if all the current assets and liability-level data is disclosed.

With this disclosure, financial market participants would have an incentive to analyze the solvency of each financial institution.  This is the basis for setting the price and amount of their exposure.

According to the Financial Crisis Inquiry Commission, a bank is solvent if the market value of its assets exceeds the book value of its liabilities.

Now for the simple solvency rule.  Regulators step in and resolve any financial institution where the amount by which a financial institution is solvent is less than 3% of the total market value of its assets.

The combination of disclosure and a solvency rule should virtually eliminate the possibility of a bailout.  Under this solution, the regulators have to step in while the financial institution still has value.

.... A few days ago, The Wall Street Journal wrote an editorial applauding the recent suggestion byDaniel Tarullo, a Federal Reserve governor, that the biggest banks hold as much as 14 percent of assets in capital....

I should point out that the proposed international standards — Basel III, as they’re called, which are still being negotiated by regulators around the globe — would require banks to hew to capital requirements of only 7 percent, not 14 percent. 

They are also talking about adding capital surcharges of up to 3 percent, on a sliding scale, to the 30 largest, most systemically important institutions worldwide, meaning that JPMorgan Chase, for instance, would have capital requirements of 10 percent. 

There are many experts, including Admati and, one suspects, Tarullo himself, who think this is still too low. The Basel committee has already agreed, somewhat absurdly, to delay the implementation of the requirements until 2019. (Good thing the world’s banks aren’t going to have any big problems between now and then!) 

And because the Basel standards, whatever their final form, must still be enacted and enforced by individual country regulators, there is no guarantee that every country will agree to them. 

Here are two more reasons for adopting disclosure of current asset and liability-level data.  First, it can be done well before 2019.  Second, it is the sort of standard that every country can agree to as disclosure does not negatively impact the competitiveness of their banks.

... Indeed, every argument put forth by the big banks and their Congressional spokesmen against higher capital requirements have been demolished by Admati as well as Simon Johnson, the banking expert, whose devastating rebuttal can be found in The New York Times’s Economix blog. But the idea that they will make U.S. banks less competitive with European banks deserves particular scorn. 

European banks, to be sure, have fought fiercely against higher capital requirements. It’s not really because they hope to get a leg up on the rest of the world, though. It is because these banks are in far worse shape than the banks in other parts of the world; they can’t afford higher capital requirements. If Europe began insisting that its banks begin holding enough capital to cushion against all the risk on their books — starting with Greek debt — the truth would be out: Their insolvency would suddenly be apparent. If Europe wants to keep kicking the can, by turning its back on the surest measure to increase the safety of its financial system, why on earth would we want to go along? 

On what basis does Mr. Nocera know that US banks are solvent?  If European banks are insolvent, is that also not true of US banks who are exposed to European banks?  What about the US banks that are exposed to the US banks who are exposed to European banks?

[Update:  A Telegraph article on Chairman Bernanke's press conference described what he knows about the answer to the solvency question:

Mr Bernanke said that he had instructed America's banks to stress test themselves to see the effects of a Greek default. The direct exposure of such institutions to so-called "peripheral countries" in Europe was small, he said. 

However, he added that "a disorderly default would roil global financial markets" and to that extent "the impact on America could be quite significant."

Translation: depending on who is and who is not solvent, he thinks the eurozone debt problem could be

• a bump in the road - the banks have either hedged their positon or have adequate reserves marking their exposures to market;
• or the financial crisis that developed countries cannot afford as contagion causes unexpected losses.]

I began this blog by observing that the fight over additional capital is much ado about nothing.

In the absence of disclosure, neither Mr. Nocera nor anyone else knows the answer to which banks are solvent and which banks are not.  So long as no one knows, taxpayer bailouts will continue into the distant future so long as governments prudently choose not to risk the collapse of their financial systems.

That is why the most important reform is requiring banks to provide all market participants with their current asset and liability-level data in an appropriate, timely manner.  It is the only way to answer the issue of solvency.