Thursday, October 18, 2012

Senators Brown and Vitter recognize that bank capital is meaningless

In their October, 2012 letter to the Federal Reserve, FDIC and OCC, Senators Brown and Vitter argue for simpler capital requirements while making the case for why bank capital is meaningless.

Regular readers know that in the absence of ultra transparency where banks disclose on an ongoing basis their current asset, liability and off-balance sheet exposure details, bank book capital is meaningless.

This is not just your humble blogger's opinion, but also the opinion of the OECD.

The primary reason bank book capital is meaningless is because it is an accounting construct that is easily manipulated by both the banks and their regulators.

For example, regulators can engage in forbearance which allows banks to avoid taking losses on bad loans and instead engage in extend and pretend.  This overstates both common equity and assets.

Why does ultra transparency make bank book capital more meaningful?

With ultra transparency, market participants can independently assess the value of the bank's on and off-balance sheet exposures.  They can then adjust the bank's book capital to reflect this assessment.

While this makes bank book capital more meaningful, I doubt that the market participants will really care more about something else.

With ultra transparency, market participants can independently assess the risk of each bank.  With this assessment, market participants can adjust the amount and price of their exposure to each bank to reflect what they can afford to lose given the risk of the bank.

It is the adjustment in their exposures that is far more important than what the market participants calculate is the adjusted book value of the bank's capital.

It is through this adjustment that the market exerts discipline on the banks to restrain their risk taking.

Which just happens to be the outcome that Senators Brown and Vitter would like to see.
The largest U.S. financial institutions have become remarkably complex. This complexity inhibits corporate executives or regulators from properly executing their oversight responsibilities, making management, much less calculation of the proper capital standards, next to impossible. 
For example, the six largest banks currently have a combined 14,420 subsidiaries, and the Federal Reserve Bank of Kansas City estimates that it would require 70,000,examiners to study a trillion-dollar bank with the same level of scrutiny as a community bank.  It is no wonder  then that former  executives have admitted that it is impossible to fully understand all of  the positions that trillion-dollar megabanks are taking....
Institutional complexity has grown hand-in-hand with regulatory complexity.  
Morgan Stanley Chief Economist Vincent Reinhart told the Senate Banking Committee that "balance sheets of large firms have been splintered into a collection of special purpose vehicles, and securities have been issued with no other purpose than extracting as much value as possible from the Basel II Supervisory Accord."...
[The Bank of England's Andrew] Haldane argues that this complexity and opacity provides limitless arbitrage opportunities. Risk-weighting can obscure banks’ true capital situations, distorting the views of markets and regulators, and undermining confidence.
By requiring the banks to provide ultra transparency, all of this complexity would have to be disclosed. The natural reaction of market participants will be to assume that this complexity is associated with higher risk.  As a result, they will charge these banks more for funds.

This market discipline puts pressure on the banks to shrink and reduce, if not completely eliminate, their complexity.

First to go will be the proprietary bets.  Traders know that if the market can see their positions, the market can trade against these positions to minimize the profits from proprietary bets.

Second to go will be all the subsidiaries that are there no to support the real economy, but to arbitrage some complex rules and regulations.

Please note, as the banks shrink in size and reduce their complexity, market confidence is restored as market participants know they can assess the risk of the banks.

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