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