Simon Johnson's faulty capital requirements math (updated)

Bloomberg published a column by Simon Johnson in which he addressed Jamie Dimon's concerns about new regulations and higher capital requirements.

When Jamie Dimon confronted Federal Reserve Chairman Ben S. Bernanke at a conference earlier this week, he ... was pressing Bernanke to admit that the total cost of new financial regulations had not been fully calculated, and could well be holding back job growth. 

What evidence does Dimon have? He is a very smart executive with an impressive track record, but his account of regulatory changes is incomplete, to say the least. Most of what he lists are the direct effect of a credit boom that ended in a severe crisis. Some badly run firms, including thrifts and mortgage brokers, failed; structured investment vehicles, which were used to hold mortgage securities off-balance-sheet, are gone; there are no more subprime or Alt-A mortgages; markets have become more transparent; and financial institutions have reduced their leverage and increased their liquidity. 

As Dimon conceded in his question, risk needed to be brought under control and managed better by the private sector. There is nothing about this part of the post-2008 process that should be laid at the door of the government. If any financial sector blows itself up, firms fail, products disappear and everyone becomes more careful -- at least for a while. 

This is an excellent observation and deserves to be reread.

The substantive issue that seems to be bothering Dimon is capital requirements, and particularly the news that the Fed is leaning toward making large banks, such as JPMorgan, hold a 3 percent capital “surcharge” (a complete misnomer; the requirement for more equity financing relative to debt would be a buffer against losses, and not a tax.) 

To adopt Dimon’s proposed methodology, what was the cumulative effect of the previous lower capital requirements in the U.S. and globally? This part is easy -- it was the reckless risk-taking and mismanagement that led us to 2008. If you pay executives and traders on the basis of return-on-equity, unadjusted for risk, they will want to take a lot of risk, boosting payouts in the good times and handing the downside risk to someone else (ideally, from their point of view, the taxpayer). 

This is a problem with bank compensation and not capital requirements.  A well known economist calls this type of problem a "measurement error".

The realized downside risks, as handed to the taxpayer, should be measured not merely as the cost of the Troubled Asset Relief Program (TARP) or Federal Reserve rescue plans, but in terms of the increase in federal-government debt the financial crisis caused. According to the Congressional Budget Office, the financial crisis will end up increasing government debt by at least 40 percent of gross domestic product. (I’ve covered the details of this calculation elsewhere; this point is not controversial among fiscal experts.) 

Or, Simon Johnson could just have used the Bank of England's Andrew Haldane's estimate of $4 trillion in losses.

So, to turn Dimon’s question around, we know that previously low capital requirements led to social losses (those borne by taxpayers) in the trillions of dollars, as well as millions of jobs and homes lost, while the private gains were in the low billions. 

As pointed out above, the problem was not adjusting the compensation for the risk being taken.

What about the cost of raising capital requirements? On this the Federal Reserve tends to hem and haw -- as did Bernanke when questioned by Dimon on June 7. The Institute of International Finance has published estimates that suggest higher capital requirements will directly lower growth. But the institute represents global banks. And the people on its board of directors -- top management from the largest financial firms in theworld -- are paid primarily for return-on-equity, unadjusted for risk. They have every incentive to lobby for lower capital requirements. 

And the research that says increasing capital requirements will slow growth has no merit -- a point made at length by Anat Admati, Peter DeMarzo, Martin Hellwig and Paul Pfleiderer. Increasing capital requirements means more equity financing for banks, relative to their debt. Admati and her colleagues show this makes both their equity and debt safer, and shouldn’t significantly affect the cost of credit. 

A back of the envelope calculation shows this to be true.

[update:  the back of the envelope calculation looks at the impact on the borrower from varying the amount of the loan funded by common equity versus the other balance sheet funding sources.  The cost of the loan = (% funding by non-common equity funding sources * weighted average cost of these sources) + (% funding by common equity * investor required return on common equity).]

For example, investors currently require a 12% return on equity for a bank that funds its loans with 5% equity.  If the investors' required return on equity drops to 10% when a bank funds its loans with 10% equity, then the interest rate charge to borrowers has to rise by 0.10% to cover the cost of the additional common equity funding.

What would happen if regulators required banks to fund 20% of the loan with common equity?  Assuming that investors still require a 10% return on common equity, not unreasonable given the possibility of losing 100% of their investment, then the interest rate charged to borrowers has to rise by 0.50% to cover the cost of the higher level of common equity funding.

If regulators required banks to fund 14% of the loan with common equity as was suggested by Federal Reserve Governor Daniel Tarullo, the interest rate charged to borrowers would have to rise by 0.26% to cover the higher level of common equity funding.

Higher capital requirements will naturally change the way banks such as JPMorgan do business. That’s a plus, not a minus. Big banks today benefit from implicit subsidies because the market expects the government to step in and save them whenever necessary.  

If you scale back the likely subsidies by requiring much more capital, perhaps the megabanks will get smaller -- but the market can sort that out for itself. The important thing is to withdraw the implicit government support that makes JPMorgan and other large banks today’s government sponsored enterprises and contributes to the mispricing of risk throughout the world. 

Higher capital requirements do not change the implicit subsidy that banks receive.  Investors will still assume that governments will step in to save them.  Higher capital requirement could reduce the size of the bailout if the financial regulators insisted on having the shareholders absorb losses before the government steps in to save the banks.

As this blog has extensively documented, what contributes to the mis-pricing of risk throughout the world is the financial regulators' information monopoly on the useful, relevant current asset and liability-level data at the banks.

Without this information, market participants cannot analyze and properly price the risk of an investment in a bank.  If market participants cannot properly price risk, they cannot exert market discipline on the banks through adjustment of their exposure to the bank.

Dimon is right to ask for the math; this is finance, after all. But he and Bernanke [and Johnson] should be aware that the right math is staring them in the face. 

Calculate the true social costs of the existing system and weigh that against the nonexistent social costs of significantly increasing capital requirements.[ending the financial regulators' information monopoly.]  We should be going far beyond the higher capital requirements that the Fed wants to impose on JPMorgan Chase. [what the financial regulators are currently proposing to provide market participants with access to all the useful, relevant current asset and liability-level data for each financial institution in an appropriate, timely manner.]