The True Cause of the 2008 Financial Crisis and the Botched Regulatory Response (Questions and comments in subsequent post.)
The best laid schemes o’ mice and men
Gang aft agley
An’ lea’e us nought but grief an’ pain
For promis’d joy!
– Robert Burns
Oceans of ink have been spilled in attempts to explain the 2008 Financial Crisis. Yet its true causes remain obscured by a fog of myth and bias. Now, with a decade’s distance, it seems like a good time to take a deep breath and consider what really did cause the crisis.
Spoiler alert; Hollywood got it wrong. The financial crisis was not caused by subprime lending, or CDO’s, or CDS’s, or savings gluts, or Glass Steagall repeal, or even “Greedy Wall Street Bankers”. Some of these played ancillary roles, but they were small potatoes.
So, what did cause the crisis? In a word: regulation. Bad regulation. Mainly, the Basel Capital Standards. Many have criticized these standards for not preventing the crisis, but few appreciate their role as its central underlying cause.
If I am correct and regulation did cause the crisis, then all the lessons we have drawn from it are wrong. The crisis was not a case of free markets run amok, but of excessive regulatory hubris. It was a failure of government, not capitalism.
With typical American myopia, experts and lay folk alike remember the 2008 financial crisis as a purely domestic disaster. Europeans like to pile on this myth, bloviating at the evils of American capital finance. So one can be forgiven for not noticing that the 2008 crisis was above all a European crisis (and still is.) It was limited to the European banks and the US shadow banks. In fact, the great untold secret of the crisis was the strength of the US commercial banking industry. The Draconian regulatory response to the crisis — Dodd-Frank — was completely unnecessary and deeply destructive to the banking industry and the overall economy.
The story is a simple one. So simple, in fact, that I’m astonished that so few have focused on it.
A brief word about bank capital. Because banks are highly leveraged, and because debt values are fixed while asset values fluctuate (that loan may never be repaid), regulators rightly require banks to carry a minimum capital base with which to absorb unforeseen losses. Historically, regulators have required every $100 in assets to be supported by roughly $95 in debt and about $5 in equity — a 5% “leverage ratio.” Very simplistically, 5% equity allows a bank to incur a 5% reduction in the value of its assets – a loss to shareholders– before it becomes insolvent and deposit values are compromised. This is roughly analogous to buying a $100,000 house with a $95,000 mortgage and a $5,000 down payment. If the house drops in value by 5%, it’s your loss. Beyond that, the bank takes the hit. The most you can lose is $5,000. (And your house.)
Basel I was promulgated in 1988 to establish a new regime for bank capital standards. The new rules made sense in theory as regulations occasionally do. Instead of a fixed capital requirement for a bank — requiring, say, a leverage ratio of 5% across the board — Basel tried to make capital requirements proportional to a bank’s balance sheet risk. Its method was to assign “risk weightings” to each class of assets. Thus, a bank whose assets consisted of risk free assets like Treasury Bills would need to hold very little capital, while a bank specializing in construction lending might need to hold much, much more.
Fair enough. But Basel I had three fatal flaws: 1. There was no lower limit on a bank’s leverage ratio. This would prove to be a crucial distinction between European regulation and more conservative U.S. regulation, which retained a leverage constraint. 2. Basel allowed large banks wide latitude in valuing their own trading books. 3. The risk weightings were arbitrary and, in the end, proved wholly bogus.
Basel I incentivized European banks to become much bigger and more highly leveraged. As long as banks were adding assets that Basel deemed “low risk”, there was virtually no limit to the size of a bank’s balance sheet or the leverage a bank could attain.
Think for a minute about the implications of this balance sheet boom. First, heightened leverage made the financial system far more unstable, as a top-heavy ship is vulnerable to a rogue wave.
More importantly, Basel stoked an insatiable appetite for all assets, but especially those that Basel (erroneously) classified as “low risk.” Things like AAA rated subprime MBS and Greek sovereign debt (oops.)
Just how big was this Basel-driven demand for assets? Massive, stupendous, and colossal are three descriptors that come to mind. But they are woefully inadequate.
European banks in 2007 had aggregate tangible equity of roughly 1 trillion euros (at the time, about $1.1 trillion.) With a sensible leverage ratio of 5.0%, this equity would have supported E20 trillion in assets. But by 2000, the average European bank leverage ratio already had dwindled to 3.8% (insufficient), and then fell further — to 3.0% (wow) in 2007.* That may not sound like a big deal, but it’s more than a 20% system-wide increase in leverage in just 7 years. This meant that for European banks alone, the Basel Regs goosed asset demand by at least E7 trillion ($8 trillion).** To think of it another way, European bank assets in 2007 exceeded what would have been prudent leverage (i.e. 5%) by E13 trillion ($15 trillion) — a third of European banking system assets.
This is, I believe, a conservative estimate, and these are very, very, very, big numbers. Eight trillion dollars was far more than the total US issuance of sub-prime mortgage backed debt in the 2000’s. It was many multiples of Chinese dollar holdings. Eight trillion dollars was roughly equivalent to the US national debt in 2007.
The biggest European universal banks drove most of this demand, largely through their United States dollar-based offices. Here, they found easy funding through money market funds and gorged themselves in our bountiful capital markets. (For a far more elegant treatment of this issue, I strongly recommend reading “The Global Banking Glut” published in 2012 by Hyun Song Shin.) By 2007, leverage ratios for these banks were wafer thin, even though by Basel standards capital remained adequate. Some banks were off the charts. The leverage ratio for Barclay’s was 2.1%, and for UBS 1.4%. Even mighty Deutsche Bank, that paragon of financial probity, was leveraged nearly 100 to 1.
Leveraging US shadow banks (including Lehman, Countrywide, WAMU, General Motors, and especially Fannie and Freddie) contributed further trillions to the European demand. These entities were not regulated by commercial bank authorities (the Federal Reserve, the FDIC, and the Controller of the Currency) and were not subject to Basel or the more conservative US bank capital standards. The much-decried leverage of US brokerage houses was largely a competitive response to the Basel-driven leveraging of the European universal banks (along with some poorly timed capital liberalization from the SEC.)
Importantly, these superfluous assets were overwhelmingly funded short term, typically overnight. Thus, European banks became extremely vulnerable to runs if (when) short term creditors got jittery. Runs don’t occur because short term creditors know something bad is going on. Runs occur because short term creditors think something bad might happen and want to get their money out before anyone else gets wise. Shoot first and ask questions later is always the default strategy. That is why it is essential for the central bank to stand foursquare behind the funding of every bank in the system.
The mechanisms that enabled financial institutions to borrow in such obscene amounts were the Asset Backed Commercial Paper and Repo markets (see any number of superb books and articles by Gary Gorton.) Because short term financing was ostensibly “collateralized,” there was an illusion that these loans were without risk. But as things came apart, collateral values plummeted, bids evaporated, and ultimately lines to banks were pulled entirely. (This means that “Moral Hazard” was not a major incentive for bank funding, let alone for that of SIV’s. Secured funding on an immense scale was readily available for institutions both with and without implied government guarantees.)
Credit standards declined as well. One of the most powerful concepts in economics is “the law of diminishing marginal returns.” As European banks and shadow banks reached for that marginal asset, they increasingly had to compromise on credit quality. Deferring to Basel’s guidance, most did not understand (or chose to ignore) the risk inherent in these assets, and rating agencies happily abetted this willful self-delusion. Turned out that as long as one could borrow and was not too choosy about credit, one could always find an investment bank willing and able to whip up that marginal asset and feed the beast. If it smelled a little too much, no problem. A small fee to AIG got you a credit default swap. Hey presto, AAA.
Much of the leveraging I describe was done with derivatives. For instance, the value of UBS’s derivatives book soared from E26 billion in 2002 to E450 billion in 2007. Now, derivatives are very useful tools. Properly managed, such increases would not necessarily have heightened risk for a bank or for the system overall. But too often, these derivatives were used to create “synthetic” assets structured to skirt Basel standards and boost trader bonuses. Remember that Basel allowed banks to value most derivatives using their own internal models. Moreover, as we now all know from the “London Whale” fiasco, even derivative positions intended as conservative hedges have a funny way of ballooning out of control.
Worse, this explosion in derivatives engendered a silent, insidious rise in systemic counter-party risk. Off balance sheet SIV’s exacerbated this problem. When crunch time came, there were hundreds of trillions of dollars of notional claims piled on top of tens of trillions of book commitments, with no capital to back them up. No European bank could have any confidence in the ability of any counter-party to meet its obligations. Moreover, since each European country had its own regulatory and bankruptcy regime, it was unclear how these claims would be resolved even if the counter-parties could be identified and held accountable.
So we can see that, far from causing the crisis, the subprime bubble was simply the bastard child of Basel I. By allowing minimal capital to be held against assets that turned out to be garbage, Basel created an appetite for these assets that would not otherwise have existed.
The important point is that, in January, 2008, there was an immense overhang of dodgy longer term assets held by a variety of egregiously leveraged players, most of it funded overnight. The Basel I capital standards mandated a European banking system that was like a forest overstuffed with dry tinder. The subprime crisis was just the spark that set it all alight.
Only a select few experts have correctly identified Basel as the principal cause of the financial crisis. One is Jeffrey Friedman in his 2011 book Engineering the Financial Crisis. In it, he focuses on the “Recourse Rule”, an offshoot of the Basel II discussions that reduced by 80% the capital required for AA and AAA rated tranches of private asset backed securities. Adopted in 2001, the Recourse Rule allowed US-based banks to employ dramatically higher leverage if deployed in “low risk” RMBS.
In What Caused the Financial Crisis?, a 2011 book edited by Friedman, Juliusz Jablecki and Mateusz Machaj delve into fascinating examples of arbitrages that banks could engage in to employ the least possible Basel capital and still achieve effectively the same economic profit. Here is one of the more straightforward: “A bank would benefit by originating mortgages, selling them to a securitizer, and then buying them back in the form of an asset-backed security, as long as it was rated AA or AAA or was issued by a GSE.” Such an arbitrage would have reduced the capital required to support $100 in assets from $5 to $2 with a minimal give-up in yield. Many more arbitrages, especially those involving derivatives, had the potential to reduce capital much further.
One important, and much under-appreciated, consequence of an arbitrage such as the one described above would have been that the ABS acquired were subject to fair value or “mark to market” accounting while whole mortgage loans were not. This meant that bank balance sheets were far more vulnerable to asset price changes. In 2008, as the ABS market cratered and liquidity evaporated, banks booked losses based on fictional prices that were driven by panic selling by entities desperate to cover their maturing short- term obligations or meet collateral calls. This drove the value of collateral down further – necessitating further write downs — in a death spiral that could only be relieved by the central banks.
Tamim Bayoumi’s recent book “Unfinished Business,” emphasizes the shocking latitude that Basel I granted large banks to value their own trading books. Banks had clear incentive to employ increasingly aggressive models. Moreover, he underscores the critical importance of three obscure regulatory actions that facilitated the funding of risky assets. In rapid succession, regulators liberalized the rules governing collateralization for repo, offered a “safe haven” in bankruptcy to repo holders, and reduced capital requirements for repo. These changes allowed banks to finance just about any security with ostensibly “risk-free” funds.
Incidentally, the ferocious demand for assets from 2002 to 2007 also meant that trading anything always made profits. That’s why all those bond traders on Wall Street made so much money in the 2000’s; the trade only went one way. So when we decry the billions in Wall Street bonuses for the 1%, recognize that they were just a gift from the guys and gals in Basel. We can’t really blame the traders for confusing that gift with genius.
US Commercial Banks Save the World
In contrast with their European counterparts and the “shadow banks,” American commercial banks in 2007 boasted strong balance sheets. They, too, were subject to the Basel Regs, but US managements and regulators had prudently insisted on higher capital ratios for US domestic operations than Basel permitted. Wells Fargo’s tangible ratio was 5.8%, Wachovia’s was 4.3% and US Bancorp’s was 5.3%. (I omit Citi, JPM, and BAC because of differences in accounting for their sizable derivatives portfolios.). The average leverage ratio of US commercial bank holding companies in 2007 was 5.6%***. Not only was this nearly double that of the Europeans, it turned out to be far more than adequate to weather the crisis
Crucially, the funding profiles of US banks were also far superior to those of the Europeans. This made them far less vulnerable to runs. In 2007, Wells Fargo had $500 billion in assets and only $50 billion in what one might classify as “hot” funding. Compare that to UBS, with E2 trillion in assets (ex-derivatives!) and E1.2 trillion in hot funding. Truth is, most US commercial banks were not then, and still are not in the same business as European universal banks. The Europeans had much more in common with the US “shadow-banks.” This is a fact that has evidently not dawned on US regulatory authorities.
Listening to populists pontificate today, one would think that the entire US banking industry had needed a bailout back then. But in fact, the banking industry suffered a loss in only one year and that loss was moderate — roughly $40 billion in 2008.*** If not for Citigroup and Wachovia (whose losses stemmed largely from its acquisition of Golden State, a shadow bank), the industry would have been profitable even in that dismal year.
Let me emphasize this point.
In the worst financial crisis in 80 years, the entire US commercial banking industry’s aggregate loss was less than what was spent to bail out Chrysler and GM and far less than the legal settlements paid to the US government.
Yes, some banks failed or were forcibly merged. That’s entirely to be expected, even welcomed, in a capitalist economy. Yes, TARP was imposed on the industry by government fiat, but that was completely unnecessary. Yes, Citi and BankAmerica were given equity infusions. That was unfortunate, but it is doubtful that either of these companies was truly insolvent, and, of course, the bank “bailouts” ultimately made a tidy profit for us taxpayers. In contrast to the European banks and the shadow banks, the US commercial banking system functioned effectively during the crisis and essentially as intended.
In other words, the last thing banks needed in the middle of a credit crisis was more oppressive regulation. Yet that is exactly what we got in Dodd Frank.
Dodd Frank was far more an effort to pass “landmark legislation” that aped FDR, glorified its sponsors, and punished “the banks” than it was a good faith effort to fashion an effective regulatory framework. It was an attempt to fix a system that wasn’t broke. And just as the Basel Regs produced monstrous unintended consequences, Dodd Frank has had profound negative repercussions of its own. Today’s regime of contradictory and redundant regulation has imposed a massive continuing burden on the banking industry and has cost the economy hundreds of billions of dollars with scant benefit to anyone except bureaucrats and lawyers.
Just to be clear. No one believes that the banking industry should be entirely unregulated. Deposit insurance and the Fed backstop make moral hazard a real issue. But the threat of moral hazard is way overblown. If moral hazard were really as imminent a threat as some contend, it would have been the commercial banks, not the shadow banks, that took the most risk prior to the crisis. The critical point is that, imperfect as it may have been, the US commercial bank regulatory regime ex-ante proved more than up to the job.
My belief, and I think the belief of most Americans, is that regulation is often necessary, but that less regulation is always preferable to more. It’s not that we have unquestioned faith in the free market to get the economy right. It’s just that we have a whole lot more faith in the free market than we have in the teeming minions who staff the D.C. bureaucracy.
Dodd Frank: The Big Hurt
It wouldn’t matter much if Dodd Frank and the regulatory regime it inaugurated were just unfair to bankers. Unfortunately, these policies were also profoundly destructive to the economy, stifling the incipient recovery. In the depths of the financial crisis, with credit already stanched, they discouraged banks from lending money. That pressure remains to this day. Presumably, it was not Washington’s intention to slam the brakes on economic growth. It was, however, their intention to punish “Wall Street” for purely political reasons and it is not clear that they understood, or cared much about unforeseen consequences of their policies.
A welter of regulatory post-crisis policies discouraged banks from lending and weighed on the recovery. These are just a few:
- Onerous, arbitrary, and constantly changing capital standards. For the big banks, the goal of regulators was clearly to raise capital to levels that would impair their ability to function as going concerns and force them to break up. We will examine this in more detail in ensuing pages.
- Radical restructuring (effectively, nationalization) of the mortgage industry. Again, we will touch on this further.
- Adversarial and capricious examinations at banks both large and small. With populists of both parties railing about the canard of “regulatory capture,” field examiners understood that anything less than a scorched earth examination might be a career-ender. Many examinations found deficiencies in policies and procedures that had only recently been approved of. At larger banks, immense resources were wasted on such worthless regulatory inventions as “Living Wills.”
Hunkering down, banks shrank from taking any risks that might draw the scrutiny of examiners. Managers focused on policies and procedures to the exclusion of business development. In particular, banks ceased making loans for construction and land development. This complicated the resolution of non-performing loans at the time, and contributed to today’s unbalanced single-family housing market. It also contributed to today’s widening economic inequality. Bank construction loans at the close of 2017 stood at just half of their pre-crisis 2007 level.
- Politically motivated lawsuits and settlements totaling nearly $100 billion poisoned the relationship between banks and Washington and drained capital from banks at a time when they were under pressure to raise equity. Extortion and shakedown are two terms used by more than one impartial observer (the Economist, the FT) to characterize these lawsuits. Most of the alleged misdeeds were committed not by the defendants themselves but by the institutions they had acquired, sometimes at government behest. I say that the lawsuits were “politically motivated” because the legal tsunami did not really gain momentum until early 2011 after Attorney General Holder made the bonehead comment that “Some banks were too big to jail.” This evoked vituperative demands from the populist fringe to punish the banks.
A Capital Offense
Let’s zero in on one of the most destructive of Dodd Frank’s provisions. In typically ad hoc fashion, Dodd Frank alludes only vaguely to the establishment of new capital standards for banks. Predictably, however, the regulatory agencies seized that allusion and ran 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!
Many readers will have studied Basel III in far greater depth than I have. My condolences. For those who have not, I won’t even attempt to explain them 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 ask yourself the following question: what kind of bureaucratic groupthink could possibly make this stuff up and sincerely believe it could work in the real world?
The regulatory thrust toward more onerous capital standards has been abetted by a phalanx of academics, most notably the duo Admati and Hellwig. Their diatribe “The Banker’s New Clothes” advocates bank capital ratios as high as 30%. Central to their “more-capital-is-always-better” thesis is that excess capital imposes no costs on bank investors or on society. That is, they aver that the market doesn’t care if a bank with 5% capital and an 18% ROE becomes a bank with 30% capital and a 5% ROE. 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 society. It is simply a question of opportunity costs. Such punishing standards misallocate capital both for the firm and for the economy.
The US banking industry today has roughly $15 trillion in assets. If banks are now being forced to hold 10% capital, when they really only need 6%, then $600 billion of society’s precious capital is being squandered. Many entities could put $600 billion to more productive use than just letting it molder in bank vaults. I certainly could use some. The annual cost of wasting $600 billion is uncertain, but at a cost of capital between 7% and 11% it’s somewhere between $42 and $66 billion annually.
Draconian (and constantly changing) capital standards discouraged banks from lending. 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. From 2010 to 2015, US SIFIs did both; total assets of the 5 biggest US banks actually shrank. Applauded by regulators, a trend like that is hardly consistent with robust economic growth.
Constraining big bank lending wouldn’t be such a bad thing if smaller banks were in a position to pick up the slack. But they weren’t. For one thing, small banks can’t accommodate the needs of many large bank customers. Moreover, while regulators did not impose the same onerous capital standards on small banks, direct regulatory costs fall much more heavily on smaller banks. 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 have weighed so heavily on the economy if they hadn’t also hamstrung small banks.
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 $2.6 trillion. As the economy recovered, loan portfolios grew commensurately. By 2000, eight years later, bank loans had increased to $4.6 trillion, a 7.2% compound growth rate from the bottom.
Now compare 2008 with 1990. Commercial loans peaked in 2007 at $7.9 trillion, dropping during the crisis to $7.1 trillion in 2009. Given the magnitude of the recession, one might reasonably have expected loans to rebound faster after 2009 than they did in 1992. Yet by the close of 2017, loans had grown from the bottom at a compound rate of just 3.9%. (Remember too that these numbers may be overstated due to forced mergers with troubled shadow banks.) This points to a lending shortfall of about $340 billion annually, or $2.7 trillion in aggregate, give or take.
Of course, the important question is: “If loan growth has been artificially constrained to 4% when it would otherwise have been 7% or more, what has been the impact on real economic activity?”
Now one would think that a quick call to your local 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. Historically – and with surprising consistency — $2 in nominal GDP has been associated with $1 in bank credit. This ratio has ranged from as high as 2.5 in 1993 to a low of 1.8 in 1986. Thus, at a ratio of two, a $2.7 trillion loan shortfall implies a GDP hit of $5.4 trillion over eight years. Maybe that’s too high, but even a quarter of that means that GDP was cut by nearly $170 billion annually. Not quite 1% of GDP per year, but close enough for government work. That’s a large part of the reason why the annual rate of GDP growth from 2009 to 2017 – 2.0% — was just half of what it was from 1991 to 1999 – 3.7%.
A compelling analysis by the Urban Institute (“Quantifying the Tightness of Mortgage Credit and Assessing Policy Options” March 2017) corroborates the case that regulatory constraints sharply suppressed credit markets over the past decade. In it, economist Laurie Goodman asks why the growth in single family mortgages over the past decade has been so much slower than one might have expected. She compares actual mortgage production over the past decade with what it would have been if lenders had followed credit standards prevalent in 2001-2002, prior to the sub-prime bubble.
She finds that between 2009 and 2015, as many as 6.3 million fewer mortgages were made than would have been made under the more reasonable 2001-2002 standards. At an average of $150,000 a pop, that points to $945 billion in foregone credit and well over a trillion dollars in foregone home sales. Worse, since the credit tightening represents an increase in average FICO score from 660 to 700, Ms. Goodman finds that this burden has fallen most heavily on low income citizens – typically minority groups. This has helped to exacerbate the country’s growing inequality.
Ms. Goodman identifies several key causes of this mortgage credit tightening. While she does not specifically mention Dodd Frank, many of these causes were outgrowths of the act.
Paramount among these is the “put back” rule, which falls within the category or “reps and warranties” and is a provision of the “Qualified Mortgage Rule” which took effect in 2013. Without going too deeply into the weeds, the put back rule allowed wide latitude to Fannie, Freddy, and the FHA to return a defaulting loan to an originator or deny a guaranty if any faults could be found in the original application. This means that the original underwriter can never know the true cost of any loan it sells. At any moment, Fannie can return a loan, forcing the originator to come up with hundreds of thousands of dollars and incur the cost of collection as well as a possible loss.
The result has been that most commercial banks have abandoned the mortgage market except for the most pristine credits. Many of the small mom and pop mortgage brokers that once abounded nationwide have shut down. Thus, the industry has consolidated dramatically. Those entities that today dominate the market (Quicken, Wells Fargo) are very careful to keep credit standards well above the minimums. In particular, few originators make a large proportion of high LTV loans. Thus, a major constraint on the mortgage market, and the housing market, has been the inability of prospective borrowers – especially low- income buyers — to come up with 20% down payments.
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 equity 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 the correct answer to the question: “Who cares if banks have too much capital?” is: “We should all care.” Compelling banks to hold excessive capital continues to impose 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 sophisticated 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 has not been addressed: Jimmy’s got his pilot’s license.
I hope that my comments concerning the true cause of the 2008 crisis and regulation’s potential unintended consequences have been interesting, and perhaps persuasive. Even the most theoretically effective regulations can have unanticipated repercussions far into the future. And the future is a very difficult thing to foresee.
*I derived these averages myself using available historical data. I’m confident that they are not too far out of line. They include all the large surviving European Institutions. They do not include failed banks like Fortis, nor the Greek, Baltic, or Icelandic banks. Nor do they include British building societies, Spanish cajas, or German landesbanken. Once commanding a major share of European financial assets, these institutions, of course, were vaporized.
** 7,000 = (1000 /.038- 1000 / .030). 13,333 = (700 / .050 – 700 / .030).
*** Note that these are my own estimates for bank holding companies. I was unsuccessful in obtaining aggregate numbers for BHC’s from Y9 data. A recent Fed publication shows roughly a 6.6% leverage ratio for the industry in 2007, but this seems too high. It may be based on risk-weighted assets. Also, FDIC data (which do not include holding companies or non-bank subsidiaries) show commercial banks losing money in just one year — $11 billion in 2009. My estimate probably double counts these bank-level losses and includes non-cash items like goodwill write-downs, DTA write-downs, and reserve building far beyond realized economic losses.