Stress Tests, Lending, and Capital Requirements

By James Kwak

Despite the much-publicized black eye to Citigroup’s management, the bottom line of the Federal Reserve’s stress tests is that every other large U.S. bank will be allowed to pay out more cash to its shareholders, either as increased dividends or stock buybacks. And pay out more cash they will: at least $22 billion in increased dividends (that includes all the banks subject to stress tests), plus increased buyback plans.

Those cash payouts come straight out of the banks’ capital, since they reduce assets without reducing liabilities. Alternatively, the banks could have chosen to keep the cash and increase their balance sheets—that is, by lending more to companies and households. The fact that they choose to distribute the cash to shareholders indicates that they cannot find additional, profitable lending opportunities.

This puts the lie to the banks’ mantra that capital requirements will constrain lending and therefore reduce growth (made most famously in the Institute of International Finance’s amateurish report claiming that increased regulation would make the world’s advanced economies 3 percent smaller). Capital isn’t the constraint on bank lending: it’s their willingness to lend.

Let’s look at this a little more closely. Let’s say that, instead of letting the banks increase their dividends and buybacks, the Federal Reserve increased capital requirements and said that banks had to hold onto their cash to meet those higher requirements. What would happen to bank lending? Nothing. Banks wouldn’t have to reduce their balance sheets because they already have the cash; they would just be not paying it out to shareholders.

The counterargument is this: banks only want to lend if their expected rate of return exceeds their cost of capital; but higher capital requirements increase the cost of capital (because equity capital is more expensive than debt capital); therefore the set of attractive lending opportunities will shrink.

But this is a fallacy, as spelled out by Admati and Hellwig in The Banker’s New Clothes. According to Modigliani-Miller, capital structure doesn’t affect the overall cost of capital, so retaining cash shouldn’t reduce the set of attractive lending opportunities. We all know Modigliani-Miller doesn’t hold in the real world, but the main reason it doesn’t hold is the tax subsidy for debt. (The second-biggest reason it doesn’t hold is agency costs, which dictate that more debt is bad.) In other words, to the extent that more debt lowers the cost of capital, it’s due to a distorting government intervention. The lower cost of capital due to increased leverage is a social bad, not a social good.

Bank CEOs can’t have it both ways. If the best use of their cash really is returning it to shareholders, then they might as well be keeping it in their accounts at the Federal Reserve. And that way we would have safer banks, and a safer financial system.

11 thoughts on “Stress Tests, Lending, and Capital Requirements”

  3. One mans scholar is another mans hack Pat. A friend said to me about inheritance money, he said, “Your problem is that the banks have your money”, and he was totally correct.

  4. @James Kwak “The fact that they choose to distribute the cash to shareholders indicates that they cannot find additional, profitable lending opportunities”

    Not so fast boy. There would be lot of more profitable lending opportunities if banks had been allowed to hold the same amount of capital against any asset. But, since they are allowed to earn much higher risk-adjusted returns on equity when lending to the infallible than when lending to the safe, and they cannot go against what regulations dictate, banks have decided they have had enough with exposures to the absolutely safe. Capisci?

    The Baseline Scenario site, unless its owners decide to wipe it out, is going to stand out as another shining example of those who just did not get it.

    @James Kwak “If the best use of their cash really is returning it to shareholders, then they might as well be keeping it in their accounts at the Federal Reserve. And that way we would have safer banks, and a safer financial system”.

    What? Do you really think we have a safer banks system (and a safer real economy) because banks hold their cash at the Federal Reserve? With regulators like that… they (and we) are much better off, if bank shareholders getting their cash out and go into the shadows and operate without being distorted.
    @James Kwak, Admati, Hellwig, Modigliani Miller “capital structure doesn’t affect the overall cost of capital”
    What, do you mean that different capital requirements do not affect who banks lend to?

    @James Kwak, Admati, Hellwig, Modigliani Miller “capital structure doesn’t affect the overall cost of capital”

    What, do you mean that different capital requirements do not affect who banks lend to?

  5. Per, we “get it” just fine. You on the other hand seem to be missing something and it is not cash, power perhaps, or a different reasoning which right now does not seem logical to you. Did you believe you had every angle covered and one is going wrong? We get people out of danger one at a time, and over an extended period of time, or we try again somehow until it works. I don’t think your group is among that chosen few, sure you know to confiscate funding and throw it around as you wish, but don’t be disappointed and pretend to take the ball away,or hurl some BS on someone else’s playground, in hopes that when you do leave it will ruin the party, so you can get back to more forward thinking schemes. Your cookie is about to crumble and humpty has yet to fall off the wall.

  7. The main variables are risk exposure, equity, and deposits. If the goal is to limit losses on deposits, sure enough you can regulate risk and require equity, but why not limit deposits as many distinguished economists at times advocated (Chicago plan, full reserve banking, etc.)

    Any deposits that the bank takes do have to be insured and bailed out by the state but what if interest rates were negative above, say $50k, forcing savers to buy bonds or risky securities instead? Why wouldn’t that solve the problems of fragile banks, weak economy, and bailouts all at once?

  10. James: I couldn’t have this argument more elegantly or effectively myself. Readers who don’t get this argument don’t get basic financial economics.

    Full reserve banking would shrink the economy by a factor of 15 (GDP * 1/15). Good idea. Negative interests would come from where? Government fiat? Fed Reserve fiat? American Bankers Association fiat? Money Center Banks fiat? the reversal of time?

  11. I believe the idea is to break bank money into two pools: A small stock of riskless deposits (or cash) and a large stock of something liquid but risky that you can save and use to pay for large transactions. Europe seems to be sleepwalking into this arrangement with a Euro in one bank not being worth a Euro in another bank, and I wouldn’t suggest that anyone follows us but perhaps a better way of exposing credit risk to bank depositors would be productive.

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