Your humble blogger's response is that banks do not need to be immediately recapitalized. Instead, banks can rebuild their book capital levels over several years by retaining 100% of their pre-banker bonus earnings.
This is not the response that the global policymakers or financial regulators would give. Nor is it the response that almost every economists would give, particularly those who are calling for banks to hold more capital.
The fact that I am in the minority in how I responded to this question puts the onus on me to show why I am right.
To show this, we need to start with a solvent, opaque bank. The traditional definition of a solvent bank, which comes from the Financial Crisis Inquiry Commission, is the market value of its assets is greater than the book value of its liabilities.
Assets
Cash 5
Bonds
Government 10
AAA-rated 15
Loans
Performing 70
Non-performing 0
Total Assets 100
Liabilities & Equity
Core Deposits 70
Hot Money deposits 20
Equity 10
Total Liab. & Equity 100
Not only is this bank solvent, but it has terrific capital ratios. It shows a simple equity to asset ratio of 10%. Its Basel I, II or III capital ratios are even better.
Unfortunately, it turns out that this opaque, solvent bank was heavily exposed to subprime mortgages, commercial real estate and other areas of the financial system that collapsed at the beginning of our financial crisis. The effects on this bank of marking all of its assets to market are shown below [AAA-rated bonds suffer loss of 10; loans suffer loss of 10; equity absorbs loss on bonds and loans and declines by 20].
Assets
Cash 5
Bonds
Government 10
AAA-rated 5
Loans
Performing 45
Non-performing 15
Total Assets 80
Liabilities & Equity
Core Deposits 70
Hot Money deposits 20
Equity (10)
Total Liab. & Equity 80
Clearly, this banks is insolvent as the market value of its assets (80) is less than the book value of its liabilities (90).
Please recall that this bank is also opaque. It provides the required disclosures that the Bank of England's Andrew Haldane would say results in its being like all the other banks, a 'black box'.
Naturally, this opacity is very important as it gives policymakers and financial regulators a choice: make the bank publicly acknowledge and absorb its losses upfront or allow the bank to hide the true extent of its losses and slowly absorb them into earnings over the course of time.
Please note that regardless of which choice is made the bank is still insolvent under the traditional definition.
What the choice comes down to is when do the bank's financial statements reflect its true condition. Now or at some point in time in the distant future.
If the financial regulators want to hide the true extent of the bank's losses, they can suspend mark to market and adopt mark to model accounting for its securities. The financial regulators can also engage in regulatory forbearance and let banks practice 'extend and pretend' to turn non-performing loans into 'zombie' loans.
Both of these were done by global policymakers and financial regulators in response to our current financial crisis.
The impact of these actions is shown below for our now insolvent, opaque bank.
Assets
Cash 5
Bonds
Government 10
AAA-rated 14
Loans
Performing 65
Non-performing 4
Total Assets 98
Liabilities & Equity
Core Deposits 70
Hot Money deposits 20
Equity 8
Total Liab. & Equity 98
Please note that the bank's book capital, which is an accounting construct, no longer reflects the true condition of the bank (it is a positive 8 when the bank's true condition shows minus 10).
As Sheila Bair would say: as a result of measurement errors, this bank's capital is deceptive. It doesn't present an accurate picture of the bank's risk or solvency.
Before going on, let me summarize three key points.
- First, the bank is insolvent under the traditional definition of solvency regardless of what its financial statements show.
- Second, by fiddling with the accounting, policymakers and financial regulators are explicitly agreeing with me that a bank can operate and support the real economy even when it is insolvent under the traditional definition.
- Third, by fiddling with the accounting, policymakers and financial regulators are explicitly agreeing with me that a bank that is currently insolvent under the traditional definition can generate and retain enough earnings so that it becomes solvent again.
The answer to this question is driven by their answer to how quickly banks need to be recapitalized after recognizing losses. They assert that banks need to be recapitalized as soon as possible after recognizing losses.
Why?
Because a bank that shows low or negative book capital levels is prone to bank runs or it is hampered in its ability to support the real economy.
Let me address bank runs first.
Why should this bank be any more susceptible to bank runs after it reveals the true extent of its losses than it is when the losses are being hidden? Do global policymakers and financial regulators think that market participants missed the implosion of subprime securities, commercial real estate and other areas of the financial system?
What market participants don't know is the exact extent of the losses suffered by each bank. Market participants are keenly aware of the fact that each bank suffered extensive losses. Losses that if fully recognized upfront may in fact leave the bank with substantial negative book capital levels.
So why aren't depositors fleeing the banks? Deposit guarantees and access to central bank funding.
I break depositors into two groups: core and hot money.
Core depositors like individuals and SMEs have a long-term relationship with their bank. They trust that even highly indebted governments will honor their deposit guarantees and protect them from any losses due to bank insolvency. As Cyprus shows, hurting the SMEs devastates the economy so policymakers and financial regulators have a strong incentive not to do this.
As a result, core depositors don't care and probably couldn't tell you what the book capital level for their bank was at the end of last quarter. They are with their bank for the long haul.
This is a key point because it is these depositors that are the key to the viability of the banking franchise. It is their business that allows a bank to generate and retain the earnings that rebuild its book capital level and restore it to solvency over many years.
Hot money depositors are, as their name implies, only dealing with the bank as an investor. At the first sign of problems and clearly this bank has problems, they are gone as soon as they can get their money out.
This group is in fact already engaged in a bank run. A run that is slowed down to a jog by having their money tied up in time deposits.
So what does the bank look like after all of its hot money depositors have left?
Assets
Cash 5
Bonds
Government 10
AAA-rated 5
Loans
Performing 45
Non-performing 15
Total Assets 80
Liabilities & Equity
Funds from central banks 20
Core Deposits 70
Hot Money deposits 0
Equity (10)
Total Liab. & Equity 80
Please note that under Walter Bagehot's principle for central banks acting as lender of last resort, central banks are suppose to lend freely against good collateral. In this example, good collateral at 60 is 3 times greater than the size of the loan from the central bank. So a bank run by hot money depositors is not a problem.
This example is all well and good, however, in the EU, the ECB is restricted to only lending to solvent banks.
Let's not kid ourselves. The fact is that all the large banks in the EU, UK and US are insolvent whether their financial statements show it or not.
First, a bank that was not insolvent would provide ultra transparency to show it. By disclosing its current global asset, liability and off-balance sheet exposure details, the bank is saying it has nothing to hide. This would give it an enormous competitive advantage in both access to and lower cost of funds over other large banks that don't make a similar level of disclosure.
Banks that don't provide ultra transparency are announcing they have something to hide and are far riskier.
Second, the existence of deposit guarantees would change Walter Bagehot's definition of solvency. It would no longer be solvency as defined by the Financial Crisis Inquiry Commission. It would be adjusted for the existence of the deposit guarantee standing behind the core depositors.
The deposit guarantee implies a far higher level of "capital". One way to reflect this is to subtract the guaranteed deposits from the solvency equation. A bank is solvent if the market value of its assets exceeds the book value of its liabilities less guaranteed deposits.
In our example, our insolvent bank under the traditional definition of solvency is solvent after adjusting for the deposit guarantee [80 - (90 - 70) = 60].
This is very important. As regular readers know, the time to resolve a bank is when the interest income from its performing assets does not exceed the combination of its interest expense and its pre-banker bonus cost of operations.
Please note, the ECB is already effectively using my modified definition of bank solvency and lending to banks that would be insolvent under the Financial Crisis Inquiry Commission's solvency definition under its promise to do whatever it takes. There is no reason to believe that the ECB is fooled by EU policymakers and financial regulators playing games with the banks' financial statements.
Let me now address the issue of recognizing the losses would hurt the banks' ability to support the real economy.
Why?
As shown in the example, there is no reduction in the bank's ability to fund new loans after it absorbs its losses. Cash didn't change.
Recognizing the losses actually improves a bank's ability to make loans. As shown by Iceland, when the banks recognize upfront the losses on all the excess debt in the financial system, collateral values adjust to a sustainable level. This is important as banks are senior secured lenders.
What limits the ability of banks to make new loans is an artificial construct: regulators and their obsession with easily manipulated book capital.
Quite simply, it is not access to funding that hurts a bank's ability to fund new loans and support the real economy as it is the constraint on making new loans that the regulators force on the banks in the form of capital ratios.
It is the bank regulators who insist on a positive capital ratio even when the bank should be showing a negative book capital level.
No comments:
Post a Comment