Thursday, June 7, 2012

Morgan Stanley confirms no connection between high capital ratios and investor confidence

One of the ways that bank regulators and economists continue to embarrass themselves is with their obsessive focus on financial institution capital ratios.

Honestly, they need to get over it.  Especially since the OECD said that with regulators practicing regulatory forbearance both bank capital and bank capital ratios are meaningless.

Capital ratios are meaningless because everyone knows the banks are hiding losses.  For example, earlier this week I ran a post on how UK banks are sitting on billions of undeclared losses (by the way, the banks now claim that the estimate is high ... my response to the banks is prove it and provide ultra transparency so everyone can see what the undeclared losses on and off your balance sheet really are ... they won't provide ultra transparency because they have something to hide ... are the undeclared losses an order of magnitude greater than is currently being discussed).

Everyone knows that policymakers and financial regulators chose continuing payment of banker bonuses by adopting the Japanese model over protecting society and the real economy by adopting the Swedish model for handling a bank solvency led financial crisis.

At the heart of the Japanese model is the focus on protecting bank book capital levels at all cost.  One of the ways of doing this is through regulatory forbearance under which banks do not have to recognize the losses on all their bad debt.  Market participants know this and hence they know that capital ratios are meaningless.

In case market participants forget how meaningless capital ratios are, EU financial regulators have run stress tests the last couple of years.  After each stress test, banks the regulators claimed were adequately capitalized and passed the stress test had to be nationalized.  Can regulators and economists say capital ratios are meaningless?

Regular readers know that the source of confidence in the financial system is transparency.  Specifically, providing market participants with access to all the useful, relevant information in an appropriate, timely manner so that investors can make fully informed investment decisions.  A fully informed investment decision means the investor had a chance to use the disclosed information to independently assess the risk of the investment.

The reason transparency brings confidence to the market is that investors trust their own assessment of the risk.

Please note that capital is an accounting construct.  It is subject to manipulation.  By requiring banks to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details, investors have access to information that cannot be manipulated.  Hence the reason that investors trust their assessment of this information.

Bloomberg ran an article confirming that high capital ratios do not restore investor confidence.

Regulators and [economists] have touted higher capital ratios as the path for banks to restore confidence. Morgan Stanley (MS), the best-capitalized Wall Street firm, is proving that’s not enough. 
Morgan Stanley has the highest Tier 1 common ratio among the five largest U.S. investment banks, topping JPMorgan Chase & Co. (JPM)Bank of America Corp. (BAC)Citigroup Inc. (C) and Goldman Sachs Group Inc. (GS) Still, it faces the largest potential downgrade from Moody’s Investors Service, has the highest-priced credit-default swaps and trades at the biggest discount to liquidation value. 
The firm’s underperformance highlights Chief Executive Officer James Gorman’s difficulty convincing investors that his is a different company than the one that borrowed more than $100 billion from the Federal Reserve to survive in 2008. Morgan Stanley also faces doubts after JPMorgan, the only U.S. bank with more credit-default swaps on its balance sheet, announced a $2 billion loss from derivatives trading. 
“With the recent surprise with what happened at JPMorgan, we are all very skeptical of what’s on those balance sheets that we as outsiders can’t figure out,” said Charles Peabody, an analyst with Portales Partners LLC in New York, who has a neutral rating on the stock. “Morgan Stanley has not proven in recent history to be good risk managers.”...
Please re-read the highlight text as it summarizes why only disclosure restores investor confidence.
“Capital doesn’t seem to be solving all the problems,” said Shannon Stemm, an analyst at Edward Jones & Co. in St. Louis. “Compared with the European banks, a lot of the U.S. banks look really well-capitalized, yet that’s still not helping them. They’re still trading at half of book value, just like the European banks.”...
That is because everyone knows that with the Japanese model and regulatory forbearance capital is significantly overstated.

Without ultra transparency, banks are 'black boxes' and investing in them is blindly betting.
Morgan Stanley and its competitors have faced declining trading volumes and low merger activity as investors and companies remain wary about the European debt crisis and the U.S. economy.  
David Trone, an analyst at JMP Securities LLC in New York, downgraded all five banks to market underperform on May 21, declaring them “un-investible” because of macroeconomic threats....
The lack of transparency into the current exposure details means that there is no way to evaluate the impact of these macroeconomic threats.

This analysts appears convinced that the threats are likely to overwhelm the meaningless reported capital.

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