Debunking the myth of bank capital as the key to a stable financial system

Before debunking the myth of bank capital as the key to a stable financial system, I want to remind readers that my view of requiring banks to hold more capital is that it is like chicken soup, it can't hurt.  However, like chicken soup, it neither prevents nor frequently cures the disease.

If I could have one reform, I know that with market participants having access to all the useful, relevant information in an appropriate, timely manner, I will not only get the benefits of disclosure like market discipline, but also all the benefits that the advocates of higher capital requirements are seeking.  Having said that...

Bloomberg ran a column in which it asked the question "how much capital does a big bank really need to be safe?"  Its editors answered by supporting the conclusion of the Bank of England's David Miles and economists like Anat Admati in their call for banks to have a capital ratio closer to 20 percent.

Not long ago, U.S. Treasury Secretary Timothy Geithner described the key ingredient in a sound global financial system: “Capital, capital, capital.” He’s right about the ingredient.

Actually, Mr. Geithner and the Bloomberg editors are fundamentally wrong about capital as a key ingredient.  The lesson of both the Great Depression and the Great Recession is the key ingredient for a sound global financial system is disclosure, disclosure, disclosure.

Look at the parts of the financial system that failed (like structured finance and regulated financial institutions in the Great Recession) and you will see that they are characterized by opacity.  Where opacity means that market participants did not have access to all the useful, relevant information in an appropriate, timely manner.

Look at the parts of the financial system that functioned (like the stock market in the Great Recession) and you will see that they are characterized by disclosure.  Where disclosure means that market participants had access to all the useful, relevant information in an appropriate, timely manner.  With this disclosure, market participants were able to do their homework and adjust based on risk both the price and amount of their exposures.

Bank capital suffers from many well known incurable measurement errors that disqualify it from consideration as a key ingredient in a sound global financial system.

First, bank capital is not immune to what George Akerlof described as management control fraud.  For banks, this takes the form of management making loans to riskier borrowers and, knowing that there is not disclosure to investors of the increase in riskiness, under-reserving for losses.  By under-reserving for losses, management artificially boosts income.  In turn, this boosts the price of the stock and allows the management to profit on its equity exposure.

Accounting control fraud directly boosts common equity, the core component of capital, through higher net income.  Assuming that the bank substituted the riskier loan for a less risky loan, accounting control fraud produces an improvement in capital ratios.  In this case, higher capital ratios are not an indicator of less risk, but rather mask the increase in the bank's risk profile.

Accounting control fraud and the distortions that it creates go away with current asset-level disclosure. Market participants are able to see that a riskier loan was substituted for a less risky loan and not properly reserved for.  Market participants can in turn adjust the price and amount of their exposure to the bank to reflect the increased risk.  This market discipline acts as a brake on accounting control fraud.

Second, capital is disconnected from the solvency of a bank as current accounting standards do not require that assets in different parts of the bank's balance sheet be marked-to-market.  Even when they are marked-to-market, management has several choices as to how to do so.

This is important because the Financial Crisis Inquiry Commission observed that a bank is solvent only if the current market value of its assets exceeds the book value of its liabilities.  Capital does not directly factor into the determination of solvency.

It is only with current asset and liability-level disclosure that market participants have the necessary information to determine if a bank is solvent or not and therefore to properly price their exposure.

Third, capital is available to absorb losses, but only when permitted by the regulators.  The problem is the market does not know when regulators will use the capital to absorb losses and when regulators will engage in forbearance or extend and pretend policies and the losses that should flow through the bank's income statement do not.

Without current asset-level disclosure, market participants are likely to under-price their exposure to a bank facing insolvency given the financial regulators' statements that the bank is solvent.  This is a source of great instability and capital misallocation in the financial system.

Capital is ... also the simplest way to protect the economy from the risks big banks naturally take. The more capital banks have, the less likely they are to go bankrupt and trigger crises like the one the world is still recovering from. 

Actually, the best and simplest way to protect the economy from the risks big banks take is to require that they disclose their current asset and liability-level data.  With this data, market participants can see what risks the banks are taking and adjust both the price and amont of their exposure to reflect the risk of each bank.

... Bankers are already warning of dire consequences. If we want a safer system, they argue, we’ll have to pay for it.

Actually, one of the strengths of disclosure is that we get to have our cake and eat it too.  It is a core principle of finance that the less risk an investment has, the lower the rate of return required by investors.

With more disclosure, investors will be able to do a better job of analyzing the risk of the banks whose solvency is not being hidden by regulators.  As a result, these banks will have a lower cost of funds.  Assuming that the banks do not reduce the interest rate charged to borrowers, this lower cost of funds should translate into a larger net interest margin, improved net income and a higher stock price.

With disclosure, all market participants, including the banks and potentially the borrowers, win.  With capital requirements, borrowers clearly lose.  Proponents of higher capital levels need to go through great contortions to justify the increased costs to borrowers, but even then, they do not agree as to the perfect level of capital.

More capital means higher costs, which banks would pass on to customers in the form of higher interest rates on loans. That, in turn, could stunt economic growth by making companies less willing to invest and expand, as Jamie Dimon, chief executive officer of JPMorgan Chase & Co. (JPM), warned earlier this week. 

Logical as the bankers’ argument seems, it’s not quite right. The available evidence suggests that the benefits of fewer banking crises would far outweigh the costs of capital requirements much higher than those currently on the table. 

Consider, first, the idea that capital takes a toll on economic growth. The bank-funded Institute of International Finance asserts this would happen. Its conclusion isn’t supported elsewhere. Three Bank of England economists, for example, looked at more than 100 years of data and in a January study found no clear link between capital levels and economic growth in Britain. Other studies have found that significantly higher capital levels would push up lending rates, but no more than 0.8 percentage point, and could move them as little as 0.1 percentage point. 

The benefits of more capital, by contrast, can be considerable. When banking panics cause credit to dry up and companies to fire their employees, much of the lost economic growth is never recovered. The value of avoiding such losses, let alone the human suffering, is so great that the Bank of England team put the optimal level of capital at about 20 percent. A report from the Bank for International Settlements, the central bank for central bankers, pegged the ideal level at about 13 percent. 

Actually, more capital has never been shown to stop banking panics.  The Bank of England's Andrew Haldane has a chart that shows bank capital from the 50% range in the 1850's to the 5% range presently.  Until the imposition of deposit insurance in the 1930s, banking panics and runs on the banks were a frequent occurrence even when banks held more than 20% capital.

... Over the years, the banking system has become so complex that figuring out one large bank’s capital ratio recently required more than 200 million calculations, according to Andrew Haldane, executive director for financial stability at the Bank of England. 

Global capital rules allow banks to place different weights on different kinds of assets, leaving them vulnerable to manipulation and mistakes. Technical errors alone, Haldane estimates, can skew banks’ estimates of their capital ratios by several percentage points -- a big problem if the starting point is only 10 percent. 

The beauty of asset-level disclosure is that it allows market participants to also calculate the capital ratios.  This eliminates manipulation and mistakes.

Regulators worry that if they’re too tough on banks, they’ll create an incentive for bankers to find ways around the rules. Their concern seems misplaced. The off-balance-sheet machinations at the center of the recent crisis emerged at a time when capital requirements were as low as 2 percent. 

Disclosure should not be limited to just financial institutions but should extend to off-balance-sheet vehicles like structured finance securities.  Disclosure is not limited to banks but is needed to eliminate opacity in the financial system where-ever it exists.

The developed world is in no condition to take chances with banks. The average total debt of the U.S., Britain, Japan, and other advanced nations last year was 74 percent of annual economic output, more than triple the level in 1970. They can ill afford another major bailout. That leaves capital [disclosure] as the only barrier between taxpayers and an outcome far worse than whatever [a reliance on capital and its] slightly higher interest rates might produce. 

Reliance on capital continues to place the regulators in a position to a) gamble on redemption for failed financial institutions or b) resort to bailing out a failed institution.  With disclosure, it is clear when a financial institution is approaching insolvency and the regulators should step in and resolve the firm.

It’s hard to know what the perfect capital ratio is. But given the lopsided risks, it would be wise to err on the high side. The burden of proof rests on global regulators to justify why they aren’t aiming for a capital ratio closer to 20 percent.

With disclosure, it is unnecessary to know what the perfect capital ratio is.

What is easy to know is that the perfect amount of disclosure is all the useful, relevant information in an appropriate, timely manner so that investors can make a fully informed investment decision.  Regulators should err on providing too much data as anything less represents opacity that the developed world and the global financial market can ill afford.