Wednesday, October 12, 2011

Banks have capital for a reason - In Europe, it is time to use it

The Guardian ran an interesting article asking the question:  how much capital should Eurozone banks hold.

Under the current circumstances, the FDR Framework would suggest none.  In fact, banks should have a negative equity balance if that is what is required to recognize all the losses they hold on the asset side of their balance sheet.

The whole reason banks have capital is to absorb losses so that the losses do not damage the real economy.

There are three facts about bank capital that are critical for reaching this conclusion.
  • First, bank capital is an easily manipulated accounting construct. It is not some sort of rainy day fund that has been set aside just waiting to be used.
  • Second, bank solvency is independent of bank capital.  It is a function of the relationship between the market value of the bank's assets and the book value of the bank's liabilities.  When the market value of the assets exceeds the book value of the liabilities, the bank is solvent.  When the reverse is true, the bank is insolvent.
  • Third, banks can be insolvent and continue to make loans until they are closed by the financial regulators.  For example, the US regulators let the insolvent savings and loans operate for several years after the market realized they were insolvent.

In short, banks can operate without capital in the form of positive book equity.

Capital for banks is always an accounting construct.  If it is reduced to a negative number, it does not mean that the bank has to go out of business or that it has to stop making loans (it probably does mean that all bonuses and dividend payments will have to be in shares while book capital is a negative number though).

Unlike a non-financial company, a bank with negative capital can stay open as long as regulators permit it.

In Europe, the time has come to put the bank capital to use absorbing losses on sovereign and private debt.  If necessary, all of the capital plus more should be used?  After all, what is it being 'saved' for?

Is it better to not use the capital to absorb the losses and allow the global economy to sink into another recession or perhaps the Great Depression II?

The capital would be used to reset debt at a level the borrowers can afford.

Why would market participants trust that the banks with their deposits and other investments if they have a negative book value?

Because, under the FDR Framework, going forward the banks are going to be required to disclose their current asset and liability-level data to all market participants.  With this data, market participants are going to be able to assess the risk of the banks and adjust the price and amount of their exposure according to the results of the assessment.
The point of this capital - largely made up of share capital - is that it should be dense enough to absorb losses so that banks can keep the deposits for their customers safe. 
Banks argue that the larger amount of capital they hold, the less they have available to lend out. It is this point that was addressed by Bank of England executive director Andy Haldane in the summer when he pointed out that one of the ways Franklin Roosevelt helped the US out of its Great Depression was to actually reduce the amount of capital banks needed to hold to get more money flowing around the financial system. 
Haldane argued it was an "early example of macro-prudential regulation" - one of the buzz words that has emerged from the 2008 crisis. The idea is that banks build up capital during the good times - even though they do not need it - so that the cushion can be eaten through in the bad times. 
The most recent meeting of the financial policy committee, which is run under the auspices of the Bank of England and on which Haldane sits, discussed whether to copy the plan implemented by Roosevelt 60 years ago. They decided the time was not right to advocate such a move
It it worth repeating what the FPC said:
A number of members also placed particular weight on the argument that it would be premature for banks to run down their ratios now, and deplete resilience, in light of shocks that had occurred in the recent past, given the risk that larger shocks could lie ahead. But in the event that conditions did deteriorate sharply, the Committee agreed that it was important that capital and liquidity buffers were useable: it would make no sense for banks to constrain lending, thereby aggravating the adverse consequences for financial stability, because they believed that they would not be allowed to run down their buffers even temporarily to cushion the shock.
... The record of the meeting shows that there was a long discussion about whether banks should hold less capital. It was only a month ago. Now, regulatory sand appears to be shifting, with the need for more capital being debated.

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