Thursday, August 8, 2013

Why have banks been exempt from recognizing losses since beginning of financial crisis?

On the sixth anniversary of the beginning of the global financial crisis, it is time to end the myth surrounding why banks have been exempt from recognizing losses from the crisis that they created.

I have chosen to write on this topic because recently I have been involved in a series of twitter exchanges where the justification given for a whole range of monetary and fiscal policies is based entirely on the assumption forcing the banks to recognize their losses would lead to a "disaster".

But is this disaster just a convenient myth spread by bankers or is it true?  And if it is true, who is it a disaster for?  Let's look at the question of who it is a disaster for first.

Is it a disaster for public and private borrowers?  No. They have their debt written down to a level that they can afford.

Is it a disaster for homeowners when neighbors have their debt written down and house prices decline? No.  Just like stocks, it is nice to sell at the top, but this is not guaranteed.  In the meantime, the neighborhood is better off as each of the owners can afford to maintain their property.

Is it a disaster for loan origination?  No.  Banks are senior secured lenders and having the debt written down means that the value of the assets pledged as security are not artificially inflated.  Lenders have to take into account this artificial inflation in price because it is likely to not be there when the collateral for the new loan is needed as a source of repayment.

Is it a disaster for the capacity to hold loans in the financial system?  No.  Selling loans out right to private investors (insurance companies, pension funds, hedge funds) or through syndication to other banks or securitization is commonplace in the US.  In Europe, the equivalent is the covered bond.

Is it a disaster for bank book capital levels?  Yes.  Bank book capital is the accounting construct through which losses on loans flow.  When losses are realized, bank book capital declines.

Is it a disaster for bank regulators?  Yes.  Bank regulators, through the bank examiners, attempt to determine if a bank is holding enough capital to absorb any losses that arise.  When their estimation of the probability of default (PD) and the loss given default (LGF) are too low, this is exposed when banks have to recognize their losses and bank book capital becomes a negative value.

Is it a disaster for bankers?  To answer this question, we also answer the question of is the notion of disaster just a convenient myth spread by bankers.

As Economist William White pointed out, if you ask a banker, there is never a good time to recognize their losses.  This is not surprising.  Bankers have an incentive to sell the disaster myth as recognizing losses would eliminate their bonuses.

But is it true that banks recognizing their losses would lead to a disaster?

The starting point for determining if  this is true is to look at the FDR Framework and see if banks are specifically exempted from recognizing losses.

The FDR Framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).  Under the principle of caveat emptor (buyer beware), all market participants are responsible for all losses incurred on their investments.

The FDR Framework and its related legislation in the 1930s does not exempt banks from taking losses.

But what about any bank specific legislation like Glass-Steagall that was passed in the aftermath of the Great Depression or subsequently?

Again, legislation does not exempt banks from the consequences of their actions.  Legislation does however through deposit insurance exempt depositors from the consequences of the bank's actions.

But what happens if the losses at the banks are so big that disaster occurs?  Disaster for banks having large losses can only be that the taxpayers through the deposit guarantee would lose money should the losses be recognized.

Interestingly, this very scenario was planned for by the legislation that came out of the Great Depression.  By design, the legislation made banks special.  Unlike every other company, banks cannot go out of business unless the government steps in and puts them out of business.

Why can banks operate even when they have negative book capital levels or are insolvent (where the market value of the bank's assets is less than the book value of its liabilities)?

Because the combination of deposit insurance and access to central bank funding allows a bank to continue to operate.  Deposit insurance effectively makes the taxpayers the bank's silent equity partner when it has negative book capital or is insolvent.

Over the last 40 years there have been plenty of examples of banks that were insolvent but continued to operate for years.

Over the last 40 years there have been plenty of examples of banks that market participants knew would have had negative book capital levels if regulators had not intervened and prevented the banks from recognizing their losses.

Examples of banks like this include, but are not limited to, the money center banks with their exposure to loans to Less Developed Countries in the mid-1980s, US Savings and Loans with their concentration in low interest mortgages during a high interest rate period throughout the 1980s, and most recently all of the major global banks with their exposures to structured finance securities.

Please note that in each of these examples market participants were aware that the banks were or are hiding significant losses on and off their balance sheets.  Despite the existence of these losses, depositors continued to do business with these banks.

Why do business with an insolvent bank?

Because depositors don't care about solvency because of the deposit guarantee.

Why do bank regulators allow insolvent banks to continue to operate?

Because as long as the bank has the capacity to generate income in excess of its expenses it can use future earnings to rebuild its book capital level and return to solvency.  Plus the burden of paying for the disaster stays with the banks and not the taxpayers as retention of future earnings means the banks pay for their losses.

So if depositors aren't going to run and the banks are capable of generating income in excess of their expenses to pay for the losses incurred by the banks, what is the disaster lurking if banks are required to recognize their losses?

The disaster is it crushes banker bonuses.


Anonymous said...

The carrying of insolvent banks by the Fed has another effect: the misallocation of capital resources.

Bank investors would also be hurt by a write down. But they deserve to be.

The real tragedy of the recent crisis was that it caused the largest transfer of wealth from working people, that is, taxpayers, to the investor class.

Richard Field said...

I think the transfer of wealth from taxpayers to bankers is much clearer. The bankers are getting bonuses that should be used to rebuild capital levels at the banks.

The investor class is still exposed to considerable risk. Risk that an unexpected economic shock hits. With the Fed fully committed, the economic consequences could be devastating for investors.