Dodd Frank, Basel and the Equity Fetish
(Most of this post is included in “Basel: Faulty”)
In typically ad hoc fashion, Dodd Frank alludes only vaguely to the establishment of new capital standards for banks. Predictably, however, the regulatory agencies have taken that allusion and run with it, implementing unnecessarily conservative standards for smaller banks and truly debilitating ones for large ones.
As if that weren’t enough, the Basil Committee in 2012 put the finishing touches on Basel III. And if you enjoyed Basel 1 and thrilled to Basel II, just wait ’til you get a load of Basel III! We have now entered a world in which Europe and the US scrapping like schoolboys to see who can raise capital standards higher, and no bank can ever have enough. (Of course, the European banks aren’t really compelled to comply.) Recently US regulators have pulled ahead of their European brethren in the capital scrap. The Europeans are backing off as they realize just how far behind their banks are lagging and just how unworkable the current structure is.
I won’t even attempt to explain the Basel III rules or the US domestic rules in detail; it is truly mind-numbing stuff. Still, it is important to get at least a sense of what banks (and investors) are dealing with. I encourage readers to google “Davis Polk Revised Basel III Leverage Ratio”. Read it and then answer the following question: what kind of bureaucratic groupthink could possibly make this stuff up and actually think it could work in the real world?
The key point is that US regulators are intent on raising bank capital to levels unprecedented in recent years. For the bigger banks, their goal is clearly to raise capital to levels that will impair their ability to function as going concerns and force them to break up.
It is not clear to me what is motivating regulators to adopt such a draconian approach. Possibly, their motives are honorable; they believe that they are simply faithfully executing the amorphous directives of Dodd Frank. Or perhaps they genuinely believe that the Financial Crisis arose because banks had too little capital. If that’s the case, then the correct answer to the question, “How much capital is enough?” is always “more.”
On the other hand, it’s possible that their motives are less high minded. That is, they may be more focused on building their own power bases and – above all – avoiding humiliation in front of a house banking committee panel. This would explain why they are so single- mindedly intent on ensuring that no major bank fails on their watch. To accomplish this goal, they are making sure that banks abjure all risky pursuits. Pursuits such as lending money, for instance. If the economy suffers as a result, that’s not their job, man.
There are two big problems with regularly and capriciously hiking the capital bar on the big banks. First, planning for banks becomes impossible. More importantly, lending is discouraged. In case no one noticed, I’d like to point out that there are two ways to increase capital ratios. One can increase equity, or one can reduce assets. US SIFIs (ie the largest banks: “systemically important financial institutions”) are doing both. From 2010 to 2015, total assets of the 5 biggest US banks actually shrank. Applauded by regulators, a trend like that is hardly consistent with robust economic growth.
The regulatory thrust toward more onerous capital standards is abetted by a phalanx of academics keen on savaging an industry whose leaders make a whole lot more money than they do (Unfairly of course: bankers aren’t nearly as smart.) In the vanguard is the duo Admati and Hedwig whose diatribe “The Banker’s New Clothes” advocates bank capital ratios as high as 30%. Why such a high bar? Well, don’t you see, because that’s how much capital banks carried prior to the turn of the century (no, not that century, they mean 1900.) That’s ironic, since it was the 1907 panic, from which JP Morgan personally rescued the financial system, that was the genesis of the Federal Reserve in the first place.
Central to the more-capital-is-always-better thesis is that excess capital imposes no costs on bank investors or on society. That is, the market doesn’t care if a bank with 5% capital and a 18% ROE becomes a bank with 30% capital and a 5% Return on Equity. In other words, they assert that bank stock investors are indifferent between return and capital. Not only does this suggest a charming allegiance to the thoroughly discredited Capital Asset Pricing Model, it also makes one suspect that they may never have owned a bank stock.
In fact, it’s just common sense that compelling banks to carry excessive capital must impose a cost on both shareholders and on society. It is simply a question of opportunity costs. Such severe standards misallocate capital both for the firm and for the economy. The banking industry today has $15 trillion in assets. If banks are now being forced to hold 10% capital, when 6% is adequate, then $600 billion of society’s precious capital is being squandered. Many enterprises could make more productive use of that $600 billion than just letting it molder in bank vaults. I certainly could use some. The annual cost of wasting $600 bill is uncertain, but at a cost of capital between 7% and 11% it’s somewhere between $42 and $66 billion annually.
Let’s get some historical perspective to help us estimate the economic cost of incenting banks not to lend. Just prior to the previous financial crisis, in 1990, bank loans peaked at $2.9 trillion. In the depths of the recession, they bottomed out at $2.7 trillion. As the economy recovered, loan portfolios grew commensurately. By 1998, six years later, bank loans had increased to $3.9 trillion, a 6.5% compound growth rate from the bottom.
Now compare 2008 with 1992. Commercial loans peaked in 2007 at $7.9 trillion, dropping during the crisis to $7.3 trillion in 2009. Given the magnitude of the recession, one would have expected loans to rebound faster than in 1992. Yet by the close of 2015, loans have grown from the bottom at a compound rate of just 3.3%. (Remember too that these numbers are overstated due to the forced mergers of troubled shadow banks.) This points to a lending shortfall of about $300 billion annually, or $1.8 trillion in aggregate, give or take.
Of course, the important question is: “If loan growth has been unnecessarily constrained to 3% when it would otherwise have been 7% or more, what has been the impact on GDP?” Now one would think that a quick call to any economist would get you a precise answer to this question.
Unfortunately, I have been unable to scrounge even a rough estimate. So I’ll use my own heuristic. It looks to me that historically a $1 increase in real GDP has been associated with about $2 in real loan growth. If that is so, a $1.7 trillion loan shortfall points to a GDP shortfall of close to $1 trillion over six years. Maybe that’s too high, but even half of that means that GDP has been cut by nearly $100 billion annually. Not quite 1% of GDP per year, but close enough for government work.
Constraining big bank lending wouldn’t be such a bad thing if smaller banks were in a position to pick up the slack. But that’s clearly not the case. For one thing, small banks can’t accommodate the needs of many large bank customers. Moreover, while regulators are not imposing the same onerous capital standards on small banks (yet), direct regulatory costs fall much more heavily on smaller banks. Thus, if regulators command JP Morgan to hire a risk manager at $400,000 that’s a drop in the bucket. For a small bank that’s big bucks. The regulator’s war on big banks wouldn’t weigh so heavily on the economy if they weren’t also intent on putting small banks out of business.
Now let’s look at the cost of excessive capital from the standpoint of the firm to illustrate just how debilitating 30% capital levels would be for the industry and the economy as a whole. (I have not yet figured out how to insert a table into the post, so for now you’ll just have to trust my numbers.) Assume that Hypothetical Bankshares has more or less average statistics (at least by 2006 standards); 1% ROA, 7.5% leverage ratio, 13% ROE. Its anticipated growth rate is 9%. In today’s environment, such a bank would carry a P/E of about 15x and a price to book of 1.75x. That points to a stock price of $15.
Now let’s say that HYPE1 is compelled by regulators to quadruple its equity base to 30%. What will the company’s fundamental profile look like and what valuation might the market now assign it?
First, HYPE2’s ROA would probably improve a bit to about 1.25% due to the influx of free cash from its new equity. The ROE, however, will drop to 4.5%. Assuming that the bank continues to pay a 30% dividend (albeit sliced 70%), its growth rate will be cut to 3%.
So ask yourself what price you would pay for a company earning 30 cents per share, and growing at 3%. If its P/E is the same as HYPE1, it will be worth $4.50, but that would be insanely expensive, even if we assume that its required return on capital drops from 9% to 6%. A valuation of 10 times earnings would give it a price of $3.00.
Now is where things get interesting. Even at $4.50, the HYPE2 will sell at 45% of book value. At $3, it’s 30% of book. Admati and Hedwig take pains to assert that book value for a bank is meaningless. But we know different. Assuming that the assets are valued accurately, HYPE’s market value would be a pronounced discount to the liquidation value of its assets.
In the old days, the response to such pronounced undervaluation would have been obvious; buy back stock aggressively and take steps to increase profitability. Today, however, those avenues are blocked. Today there is only one rational response; liquidate the company and realize the difference between the $3 market value and the $10 book value. Why accept a 3% return from even a de-risked bank stock when I can get the same return in high grade corporate bonds?
In practice, this liquidation would most likely occur through consolidation. Inexorably, under this regime, the banking industry will consolidate until it has the concentration to force interest rates higher and achieve a competitive return on equity. That process will impose an immense cost on society, especially small businesses who don’t have access to the capital markets.
So, finally, how much capital does a bank need?
Unfortunately, most of the books I have read about the 2008 crisis (and I have read just about all of them), totally wimp out on the topic of capital adequacy. Non-committal pabulum like this is typical, “Managing bank capital is more an art than a science. In light of the crisis, it is advisable to err on the conservative side and increase capital because the optimal amount of capital cannot be known.”
Well, excuse me, but that’s just wrong. The 2008 crisis was nothing if not an unprecedented real world experiment that told us, with some precision, just how much capital banks require under rather extreme conditions. Thanks to bonehead Basel, we know that 2.0% tangible equity ratios are not adequate. (Duh.) Higher capital, say in the 4-5% range, is plenty for some well-managed, low risk companies but probably too low for a systemic standard. But, given the regulatory regime of 2007, bank tangible capital in the 6% range gave US banks in aggregate far more than sufficient cushion to allow them to withstand the worst financial crisis in 80 years and emerge nearly as sound as when the crisis started.
So who cares if banks have too much capital? As you can now see, the answer is, we should all care. Compelling banks to hold excessive capital has imposed an immense burden on both individual banks and on our economy.
Regulators and their academic apologists would take issue with this statement. As far as they are concerned, Dodd Frank has been a resounding success because the banking system is “safer” than it ever has been in the past. Meaning that banks have lots more capital. But that is far too simplistic.
Think of it this way. Say there’s an airport with a runway two miles long, more than sufficient for any plane. One day, little Jimmy loses control of his big drone and crashes it on the runway. As planes land, they struggle to avoid the wreck. Some swerve off the runway, some run off the end of the runway, but all land safely. Concerned, the FAA decides that the airport can be made safer if it spends $500 million dollars to add another 2 miles to the runway. Later, seeking to eliminate even the remotest chance for a crash, the FAA says, “We’ve run a stress test and we’ve concluded that if four drones crash simultaneously, you would need six more runway miles.” Done, at a cost of $1.5 billion. So yes, maybe the airport is marginally safer, but $2 billion has been wasted and the real problem was never addressed: Jimmy’s got his pilot’s license.
Do you remember Steve Martin’s routine “Theodoric of York, Medieval Barber?” Having just killed his patient, Larainne Newman, with a series of gruesome bloodlettings, he observes philosophically, “You know, medicine is not an exact science, but we are learning all the time. Why, just fifty years ago, we thought a disease like your daughter’s was caused by demonic possession or witchcraft. But now we know that Isabella is suffering from an imbalance of humors, perhaps caused by a toad or a small dwarf living in her stomach.”
This is today’s bank regulatory regime. Not only is it fighting the last war, it is bleeding us dry in the process.