Tuesday, October 18, 2011

Holey Grail: How much capital do lenders need?

The Economist Magazine carried an article which asked the question:  how much capital do lenders need.  The question suggests the pursuit of some ideal level of capital that banks could reach and all will be well with the global financial system.

Regular readers know that
  • Capital is an easily manipulated accounting construct.  For example, Bank of America just reported higher levels of capital by recording the decline in the market value of its debt as earnings.  So the less solvent the credit markets think BofA is by increasing the rate of return required to hold BofA's debt, the higher BofA's level of book capital.  Does it make sense to have a measure of financial strength that improves as the prospects for the bank deteriorate?
  • Capital fluctuates over the business cycle.  This is a point that has been missed with the bailouts of the banks and Europe's discussion of a 9% Tier 1 capital ratio.  During good times, capital is suppose to increase.  During bad times, capital is suppose to decrease.  Why should capital decrease in bad times?  Because losses are being realized.
  • Capital is there to absorb "accounting" losses as the losses in the market value of the bank's assets have already occurred.  For example, the financial markets realize that Greece is unable to repay its existing debt and as a result value the debt at about 40% of par value.  The value of Greece's debt has already declined regardless of how banks currently value it for accounting purposes.  Banks have capital so they can write-down the accounting value of their holdings of Greek debt to market value.
  • Capital is irrelevant for determining the solvency of a bank.  Solvency or insolvency is a function of the difference between the market value of the bank's assets and the book value of its liabilities.  Lehman Brothers showed that delaying the accounting recognition of losses on its assets and therefore reporting higher capital levels does not fool market participants into believing the firm is solvent when it is insolvent.
    • The condition under which capital is relevant for determining the solvency of a bank is when a bank holds capital equal to 100% of its assets ... then it is not a bank, but rather a mutual fund.
  • Capital is there to protect the real economy from the excesses of the financial system.  Bank capital is suppose to absorb financial excesses related to lending.  The error in judgment about the borrower's ability to repay the debt is the bank's after all.
  • Capital is not needed for banks to make loans.  Making loans is a function of bank's ability to originate.  Who holds onto the loan after it has been originated is a separate issue.  There are many market participants who could hold onto the loans other than banks - insurers, pensions, and hedge funds to mention a few.
  • Capital does not restore or maintain confidence in the banks or the financial system.  Restoring and maintaining confidence can only be achieved by each bank disclosing its current detailed asset and liability-level data.  The very fact that this data is not disclosed and banks are hiding behind failed stress tests strongly suggests that the banks have something to hide.
Each of these reasons suggests that the pursuit of an ideal level of bank capital is fundamentally misguided.

Worse, the focus of financial regulators and economists on the the notion that banks need to hold higher capital levels stands in the way of the banks recognizing their accounting losses.

To the extent that these losses are not recognized, then the orderly restructuring of the debt that needs to take place does not occur.  Without this restructuring, the market clearing value of the underlying collateral cannot be determined.  This in turn hampers the functioning of the real economy as its is difficult for banks, which are senior secured lenders, to make loans against collateral with a highly uncertain value.
THE fire raging in Europe’s financial system is growing fiercer by the day .... An obvious step to douse the flames would be to recapitalise European banks. Yet by how much and with what capital?  
Global regulations are already forcing banks to plump up their cushions significantly.
Global regulators are doing this at a time when bank capital should be declining!  If banks are not taking losses, how is debt being restructured?
Nomura reckons that simply getting banks to comply with the new Basel 3 rules, plus an additional surcharge on globally important banks, could leave European lenders, Britain’s included, needing to raise more than €100 billion ($136 billion).... 
On top of this requirement is the extra capital that banks would need to absorb losses from a recession or the debt crisis. Such calculations depend on lots of assumptions, from the amount of capital that banks ought to hold to the precise nature of any euro-zone write-downs....

Hello, what about the hole in the asset side of the banks' balance sheets from the decline in the value of the opaque toxic securities they hold as well as the decline in the value of residential and commercial real estate loans?

Just because banks have not realized the losses on their assets for accounting purposes does not mean that the market value of their assets is the same as the book value of their assets.  Remember, these same global regulators also suspended mark-to-market accounting.

The first step in the calculation of how much capital European banks need is to find out what their capital account would look like if their assets were written down to market value.  The second step in the calculation is to then look at how much additional capital they would need to comply with Basel III.

All of which underlines the need for a solution to the root cause of the problem ... “There is no amount of capital that banks could reasonably hold that would insulate them ....
This is perhaps the most compelling reason for financial regulators and economists to get over their weird fixation on bank capital.  So long as banks are not required to disclose their current detailed asset and liability-level data and are allowed to operate with leverage, they have the ability to lose more than their capital base.

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