Thursday, November 3, 2011

The fallacy of bank capital

An Irish Times article discusses Charles Dallara, Managing Director of the Institute of International Finance - a global bank lobbying group, warning how forcing Eurozone banks to achieve a 9% Tier 1 capital ratio would create a sharp credit contraction.

This warning raises a series of questions.
  • Why does anyone care about capital since it is an easily manipulated accounting construct?  
  • Would governments/financial regulators really put the real economy at risk by suggesting that there is any validity to reported bank capital levels?  
  • Does Walter Bagehot roll over in his grave every time someone attributes any significance beyond the value of a warm bucket of spit to bank capital?
Let me try to answer the questions one at a time.

Why does anyone care about bank capital?

For anyone who has ever taken a child to open up a bank account, the answer is they don't care about bank capital.  Let me explain.

At the moment your child is about to hand their money over to the nice person on the other side of the desk, they look at their parent and ask:  how do I know I can get my money back?

As a parent, your response is not to pull out the bank's financial statement, point to the lower right hand corner and say "as long as a bank has positive equity, you can get your money back".

Your response to your child is "the bank account is guaranteed by the government and it will be sure you can get your money back."

Having established why bank capital is irrelevant, let's move on to understand why bank capital is an easily manipulated accounting construct.  This requires examining what bank capital actually is.

Since the beginning of the credit crisis, US Treasury Secretary Tim Geithner has repeatedly claimed that the backstop to any shortfall in regulation is higher bank capital requirements.  In particular, he has focused on the need for more common equity because it can be used to absorb losses.

Common equity also happens to be a very important component of Tier 1 capital (the numerator in the Tier 1 capital ratio; risk weighted assets are the denominator in the Tier 1 capital ratio).

If he thinks common equity is the best form of capital and it is in the definition of Tier 1 capital, then we should look at what makes up common equity.

Common equity has three subaccounts (I ask the accountants who read this blog to pardon my simplification).
  • Par value of stock sold
  • Additional paid-in capital
  • Retained earnings
Par value of stock sold and additional paid-in capital are joined at the hip.  When the bank sells common stock, the stock certificate has a "par value".  This value is not necessarily the same as the price that the stock was sold for.  The difference between the price the stock was sold for and par value of stock sold goes into additional paid-in capital.

Par value of stock sold and additional paid-in capital reflect easily confirmed historical facts and are therefore hard to manipulate.

What is retained earnings?

By definition, retained earnings is after-tax net income minus any dividends (to common or preferred stockholders).

Like par value of stock sold and additional paid-in capital, dividends is an easily confirmed historical fact and therefore hard to manipulate.

That leaves us with after-tax net income.  

By definition, net income is an accounting construct built off of a series of assumptions.  

For banks, one of the biggest areas for assumption on the income statement is the provision for loan losses.  In theory, banks are suppose to maintain a loan loss reserve on their balance sheet that is adequate to absorb all the losses they expect to realize from the loans held on the balance sheet.  

If management thinks the losses will be greater, it is suppose to add to the loan loss reserve.  Adding to the loan loss reserve is accomplished by increasing the provision for loan losses on the income statement.  If the expected losses are high enough, not only can the provision for loan losses cause the bank to report negative net income, but it can report a negative net income that could exceed the previously reported balance for common equity.

Conversely, if management thinks the losses will be less, it is suppose to reduce the loan loss reserve.  Reducing the loan loss reserve is accomplished by the combination of charging off loan losses to the reserve and not replacing the amount charged-off with a new provision for loan losses on the income statement.

This blog has repeatedly highlighted the classic example of how the provision for loan losses is manipulated.  In the mid 1980s, John Reed and Citicorp lead the write-down of loans to less developed countries.  Citi and other banks booked a very large provision for loan losses.

Did these loans just go bad on that day?  No.  Everyone with a Bloomberg knew they had been trading at 50% or less of book value for years.

With the blessing of the financial regulators, banks engaged in "extend and pretend" with these loans.

While extend and pretend was going on, common equity was being manipulated (net income was too high, so retained earnings and therefore common equity were overstated).

So why would regulators put the real economy at risk over an easily manipulated accounting construct?

They aren't from the sense that there will be a contraction in credit.

Mr. Dallara's comments are part of the game played between the banks and the regulators.

This game is a legacy of Paul Volcker's time as chairman of the Federal Reserve.  Mr. Volcker was a firm believer that if a bank encountered financial difficulties, these difficulties should be worked out between the bank and its regulators without the market being notified.

He institutionalized this for the global financial regulatory community with the less developed country debt extend and pretend policies.

Please recall that the Fed supervised Citi.  The Fed also had Bloomberg terminals which showed several years before Citi recognized its losses that the value of Citi's less developed country loans was considerably below book value.

The Fed had to decide if Citi and the other banks should realize their losses at the time the market value of the loans declined or at some other time.  The Fed decided the banks should engage in "extend and pretend" so they could build up their common equity prior to taking the losses (do you think any bonuses were paid out on overstated earnings?)

When the banks finally realized their losses, the Fed thought its strategy had been instrumental in preventing the financial markets from collapsing.

It probably never occurred to anyone at the Fed that the market had already adjusted for the losses.  Market participants were aware the banks were carrying less developed country loans.  While they did not have the detailed specifics, they had enough information to estimate a ball park figure for the losses.  The only thing that would have caused the market to collapse when the extend and pretend policies ended was if the actual losses were an order of magnitude higher than the ball park figures.

Unfortunately, by institutionalizing the idea that hiding information from the market, engaging in extend and pretend, and saying bank capital mattered was a good idea, the Fed and the other global financial regulators set themselves up for doing the same thing when the financial crisis hit on August 9, 2007.

Mr. Dallara's warning is nothing more than the banks saying thanks to the financial regulators for another "extend and pretend" free pass.

Meanwhile, the market analysts have crunched the numbers and discovered that low and behold, the maximum amount of new equity that Eurozone banks will have to raise is trivial.

Finally, does Walter Bagehot roll over in his grave when anyone attributes any significance to bank capital?  Figuratively, YES.  Literally, no.

For readers who do not know who Walter Bagehot is, let me introduce him by way of a speech by Sir Mervyn King, the head of the Bank of England:

Banking: From Bagehot to Basel, and Back Again
Walter Bagehot was a brilliant observer and writer on contemporary economic and financial matters. In his remarkable [1873] book Lombard Street, Bagehot brought together his own observations with the analysis of earlier thinkers such as Henry Thornton to provide a critique of central banking as practised by the Bank of England and a manifesto for how central banks could handle financial crises in future by acting as a lender of last resort.
In short, Mr. Bagehot is the guy who wrote the playbook for central bankers.

So what did Mr. Bagehot have to say about bank capital?

"A well-run bank needs no capital.  No amount of capital will rescue a badly run bank."

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