More Misinformation about Banking Regulation

By James Kwak

“Fed Tells Big Banks to Shrink or Else,” the Wall Street Journal proclaimed in the headline of its lead story today.* If only.

What the Federal Reserve actually did is impose new, additional capital requirements for the largest banks. JPMorgan Chase, for example, will have to hold 4.5 percentage points more capital than it would have had to otherwise. This is clearly a good thing, since it means that the banks that could do the most damage to the financial system will be a little bit safer. But it is neither a complete solution, nor is it the draconian constraint that the banks and the Journal make it out to be.

For starters, the rule will have no effect on seven of the eight banks in question (JPMorgan is the exception), since they already have enough capital to meet the new requirements. That alone should let you know how significant a rule this is.

Even so, the Journal says that banks will have to decide “whether to pay the cost of new regulation, which will fall to the bottom line, or change their business models.” This is not true.

Say some bank has $100 in assets and $95 in liabilities, so it has $5 in capital. Its “bottom line” profits are basically the interest it earns on the assets minus the interest it pays on the liabilities. Then say Janet Yellen comes along and tells the bank that it has to have $10 in capital for every $100 in assets. So the bank sells new shares to the public for $5 and uses the $5 in cash to pay off $5 of its liabilities. Now it has $100 in assets and $90 in liabilities, so its profits actually go up (since it has less debt to pay interest on, and it pays a lower interest rate because its debt is less risky).

The banks’ complaint is not about the “bottom line,” but about something else: return on equity. Even though profits go up, they are now spread across twice as much capital. If you think of capital as the money invested by shareholders, then the shareholders are getting a lower return than they were previously. But this ignores the fact that stock in the bank is also less risky than it was before, so shareholders don’t demand as high a return on their money. Under a few basic assumptions, the return on equity is exactly what it needs to be to meet shareholders’ expectations.

This is the Modigliani-Miller Theorem, which has been around for more than half a century and is taught in every finance class. It says that a firm’s capital structure — the amount of equity it has relative to debt — doesn’t matter: in the case of the hypothetical bank, if you increase equity and reduce debt, after the reduced debt payments, there is just enough cash left over to compensate the larger number of shareholders at the lower rate that they are now willing to accept.

Now, the assumptions of Modigliani-Miller don’t hold in the real world, but the main reason they don’t hold is the tax subsidy for debt: companies can deduct interest payments on debt from their taxable income, but they can’t deduct dividends paid to shareholders. Even so, that’s not terribly hard to get around. A company can reinvest its profits in its business; as long as it finds something useful to spend the money on during the same year that it earns the profits, it won’t have to pay tax on them (because they won’t be profits — they’ll be either operating expenses or depreciation of capital investments).

Tim Pawlenty, the latest flack for the largest banks, complains that higher capital requirements will “keep billions of dollars out of the economy.” Again, this is simply not true. The amount of bank lending is dependent on the volume of lending opportunities available to banks with a risk-adjusted interest rate that exceeds their cost of capital. Since the cost of capital doesn’t change with capital requirements (except, again, because of the tax subsidy for debt), the amount of bank lending doesn’t change either.

Anat Admati and Martin Hellwig have been making these points for years now. Unfortunately, the banks, their lobby, and their water-carriers in the media persist in spreading misinformation about capital and banking regulation.

* That’s the headline in the print edition, not online.

[Also posted at Medium.]

24 thoughts on “More Misinformation about Banking Regulation”

  1. James Kwak writes: “The banks’ complaint is not about the “bottom line,” but about something else: return on equity. Even though profits go up, they are now spread across twice as much capital. If you think of capital as the money invested by shareholders, then the shareholders are getting a lower return than they were previously.”

    Yes, indeed, and then why is it that James Kwak does not get it that if banks are required to hold different capital amounts against different assets, that distorts the allocation of bank credit to the real economy.

    James Kwak writes: “the Modigliani-Miller Theorem, which has been around for more than half a century and is taught in every finance class. It says that a firm’s capital structure — the amount of equity it has relative to debt — doesn’t matter:”

    Yes indeed, but banks having to hold different capital amounts against different assets, definitely matters for the borrowers chances of having preferential access to bank credit or not.

    James Kwak writes: “Since the cost of capital doesn’t change with capital requirements (except, again, because of the tax subsidy for debt), the amount of bank lending doesn’t change either.”… that might be but if James Kwak does not understand that if a bank had to hold 100 percent of capital when lending to him, that would lead him to have less access to bank credit than those the banks could lend to holding only 5 percent in capital, then I guess James Kwak would benefit from some financial courses.

    So let me also ask…why does James Kwak insist on misinforming about bank regulations?

  2. I don’t know, Mr. Kurowski.

    Maybe because the whole discussion about banking is a moot point for the INDIVIDUAL.

    After all, 480 USA people are worth a collective total of 2.08 TRILLION and they have their own “banks”, and then some mainframes in Chicago are playing hot potato with dark pool derivatives – tossing QUADRILLIONS around in “debt” issued fiat $$$$ – and then a larger and larger percentage of people working 12 hour shifts 7 days a week do not have enough money to place in a “bank” because the bank would “fee” it away since the “workers” cannot maintain a “minimum” amount…should not the question be “who/what is the post Glass-Steagall “bank” servicing?

    And did you not get the memo that we have transformed, overnight apparently, from a “service” economy to a “sharing” economy?

  3. Mr. Kurowski,

    I guess your same argument is valid for banks in their lending to consumers and their credit-availability reducing insistence on collateral. If banks removed their collateral requirements, offered credit availability would surge. But they don’t. Given your interest in and approach to the matter why aren’t you ranting about the banks reducing access to credit by requiring collateral?

  4. Because one thing is the banks acting on the perceived credit risks, like asking for collateral, giving less credit and charging higher risk premiums…that is natural; and a completely different thing is for regulators to order the banks to hold more or less capital based on precisely the same perceived credit risks, those already cleared for by banks… that is artificial.

    Any perceived risk, no matter how perfect it has been perceived, is wrongly cleared for, if excessively cleared for.

    Suppose you had two nannies: If you averaged the risk aversion of your nannies you might be allowed to go out and play on the garden. If instead the risk aversion of both your nannies were added up, you would never see the sun. Capisci?

    What should most scare regulators is not what is perceived as risky but what is perceived as safe, and might not be.

  5. Let me repeat my argument:

    Suppose James Kwak, in the name of an unrated SME, and Per Kurowski, in the name of an AAA rated corporation, are both looking for bank credit.

    Traditionally, naturally, before risk-weighted capital requirements existed, because of the differences in perceived credit risk, Per Kurowski would be able to negotiate much more credit, and at much lower interest rates for the AAA rated corporation, when compared to what James Kwak could for his unrated SME.

    But now, because banks also need to hold more capital when lending to Kwak’s SME than when lending to Kurowski’s AAA corporation, the differences in the amounts of credit obtained and the interest rates charged would be even larger. In other words Kwak’s SME, relative to Kurowski’s AAA, obtains even less credit and needs to pay even higher interest rates, than in the absence of these credit risk-weighted capital requirements.

    Of course Kurowski does not complain that his AAA rated corporation gets more credit at cheaper rates.

    Of course the bank does not complain about being able to earn higher risk-adjusted returns on equity when lending to Kurowski’s AAA rated corporation, as a consequence of having to hold little capital and therefore be able to leverage hugely when lending to Kurowski’s AAA rated corporation.

    But James Kwak should be furious that his SME has ben denied fair access to bank credit by bank regulators.

    And of course anyone who calls himself a progressive should be furious against this odious regulatory discrimination that denies fair access to the opportunity of bank credit to those who already had it hard enough to obtain bank credit.

    And of course anyone who calls himself a free markets defender should be furious about this odious regulatory distortion of the allocation of bank credit to the real economy.

    But strangely, both James Kwak, progressives and free market believers keep mum about it all.

  7. http://dealbook.nytimes.com/2014/05/13/derivatives-markets-growing-again-with-few-new-protections/?_r=0
    One year ago The Bank for International Settlements announced that “…the global derivatives market is about $710 trillion. That is not a measurement of credit and market risks, but the figure merits attention from regulators and the public, which continues to suffer the ill effects from weakly managed derivatives portfolios in the global financial crisis. Higher volumes are a strong indication that derivatives players’ operational risk is rising.”
    ” According to the Office of the Comptroller of the Currency, the four largest derivatives participants in the United States are JPMorgan Chase, Citibank, Bank of America and Goldman Sachs, which together represent more than 30 percent of the total global derivatives market.”
    excerpted from:
    Derivatives Markets Growing Again, With Few New Protections
    By Mayra Rodríguez Valladares May 13, 2014

  8. “After the U.S. government pumped the secret, astronomical sum of more than $13 trillion into Wall Street during the years surrounding the 2008 financial crisis to bail it out of its own greedy and reckless gambles, Wall Street is shamelessly asking for more government handouts in the opinion pages of the New York Times. The woman pitching this pathetic poppycock, Kathryn S. Wylde, was actually on the Board of Directors at the New York Fed during the crisis – the very institution that sluiced the secret $13 trillion into Wall Street’s coffers.”
    read more…
    http://wallstreetonparade.com/2015/06/wall-street-front-group-pleads-for-government-help-in-new-york-times-oped/
    Wall Street Front Group Pleads for Government Help in New York Times OpEd By Pam Martens and Russ Martens: June 17, 2015

  9. http://wallstreetonparade.com/2015/07/elizabeth-warrens-glass-steagall-legislation-has-two-fatal-flaws/
    (Excerpted from : Pam Martens and Russ Martens: July 20, 2015
    Wall Street On Parade; a Citizen Guide to Wall Street

    “When it comes to sleuthing out how Wall Street has gamed the laws, conned the regulators and colluded to corrupt the whole financial system, there is no one in Congress sharper-eyed or more outspoken than Senator Elizabeth Warren, who is also exceptionally well-qualified to lead this Wall Street posse.”
    (and so)
    “Warren had this to say when she introduced the legislation, according to the Congressional Record:

    “Seven years ago, Wall Street’s high-risk bets brought our economy to its knees. The Dallas Fed estimates that the total cost of the crash was $14 trillion. Millions of families lost their homes. Millions of people lost their savings. Millions of people lost their jobs. And even today, millions of hard-working, play-by-the-rules people are still struggling to survive.

    “Over the past 7 years, we have made some real progress dialing back the risk of a future crisis. But despite that progress, the biggest banks continue to threaten the economy. The biggest banks are collectively much bigger today than they were 7 years ago. They continue to engage in dangerous, high-risk practices. And with each new headline and subsequent legal settlement, it becomes clearer that they keep chasing profits even if it means breaking the law.

    “The big banks weren’t always allowed to take on big risks while enjoying the benefits of taxpayer guarantees. Four years after the 1929 Wall Street crash, Congress passed the Glass-Steagall Act, which is best known for separating investment banks and their risk-taking from commercial banks that manage savings accounts, checking accounts, and offer other banking services.

    “For 50 years, Glass-Steagall played a central role in keeping our country safe. Traditional banking stayed separate from high-risk Wall Street banking. There wasn’t a single major financial crisis, and the financial sector helped contribute to a sustained, broad-based economic growth that helped build America’s middle class…after 12 separate attempts, Congress repealed most of Glass-Steagall in 1999.

    “The 21st Century Glass-Steagall Act will rebuild the wall between commercial banks and investment banks, separating traditional banks that offer savings and checking accounts and that are insured by the FDIC from their riskier counterparts on Wall Street.” Elizabeth Warren
    – – – – — – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – –
    The article goes on to assess the reality of legislative reforms to protect the economy FROM the BIG Banks !
    Elizabeth Warren’s Glass-Steagall Legislation Has Two Fatal Flaws
    By Pam Martens and Russ Martens: July 20, 2015
    http://wallstreetonparade.com/2015/07/elizabeth-warrens-glass-steagall-legislation-has-two-fatal-flaws/

  10. REGULATIONS work:
    “While the root cause of the financial crisis is assumed to have been the residential real estate asset price bubble, the underlying systemic risk, and the primary reason for the “too big to fail” doctrine whereby governments were compelled to save financial institutions at any cost, lies in over the counter (OTC) derivatives. The suspension of the US Financial Accounting Standards Board (FASB) mark-to-market rule in 2009 preserved the value of bank balance sheets, i.e., of their mortgage portfolios, but what was of far greater importance was that it prevented triggering the conditions of thousands of OTC derivatives contracts, such as credit default swaps (CDS), that would have wiped out virtually all of the largest banking institutions in the world.”

    Read more: http://www.businessinsider.com/bubble-derivatives-otc-2010-5#ixzz3gdOkt3Jv

  12. Bruce E. Woych writes: “The art of the deal meets the art of the steal…more chips please: ….casino banking a la carte.”

    And I sure wish we had more of a regular casino. In a regular casino each bet you can make on the roulette has exactly the same mathematical pay-off.
    Unfortunately, bank regulators, and no one but bank regulators, with their credit-risk-weighted capital requirements for banks rigged the roulette.

    http://subprimeregulations.blogspot.ca/2012/12/the-basel-ii-roulette-manipulation.html

  13. Jaime Caruana, the current General Manager of Bank of International Settlements BIS, was the Chairman of the Basel Committee for Banking Supervision when it approved that lunatic Basel II.

    Basel II approved that any assets endorsed by an AIG, an AAA rated company, would require banks to hold only 1.6 percent in capital, meaning they could leverage a mindboggling 62.5 times to 1.

    So I think you should refrain from quoting BIS as a source of financial know-how.

  14. Well your interpretations are slightly lacking too Per, and don’t ask me how, It’s a case of if you don’t know, you aint in the club.

  16. http://www.theguardian.com/business/2015/jun/08/iceland-capital-controls-financial-crisis-banking-timeline
    Iceland rises from ashes of banking crisis – timeline, The Guardian, June 8, 2015, and Iceland rises from the ashes of banking collapse,
    October 6, 2013: “From the wreckage [of 2008], only three modest domestic banks emerged, allowing Iceland to keep functioning. The country was also able to let its overheated currency devalue, and impose capital controls to bring some stability. Meanwhile, however, international bondholders and depositors were left out in the cold.”

    http://www.independent.co.uk/news/business/news/three-charts-that-show-icelands-economy-recovered-after-it-imprisoned-bankers-and-let-banks-go-bust–instead-of-bailing-them-out-10309503.html
    Three charts that show Iceland’s economy recovered after it imprisoned bankers and let banks go bust – instead of bailing them out,
    The Independent, 10 June 2015:Iceland made the shocking decision to let its banks go bust.
    Iceland also allowed bankers to be prosecuted as criminals – in contrast to the US and Europe, where banks were fined, but chief executives escaped punishment.”

  18. In USA, the radicalization of both Christianity and Capitalism happened when the criminal orgy of “Greed is good” was launched….The Patriot Act protects anyone committing crimes against humanity, whether it is economic genocide ala the math formula:

    More misery for others = More $$$$ for ME ME ME

    or “torture” which gets dismissed on a technicality playing the “words matter” game

    or good old fashioned “elimination” of pesky whistleblowers…

    Look how many years this site is running….We the People do not have the POWER or the RIGHT to stop the holy holy holy Predators because we follow the DOG MA….

    Radicalized “religion” anyone?

  19. In the case of banks, the Modigliani-Miller Theorem is absolutely inapplicable

    James Kwak writes: “the Modigliani-Miller Theorem…says that a firm’s capital structure — the amount of equity it has relative to debt — doesn’t matter: in the case of the hypothetical bank, if you increase equity and reduce debt, after the reduced debt payments, there is just enough cash left over to compensate the larger number of shareholders at the lower rate that they are now willing to accept.

    Now, the assumptions of Modigliani-Miller don’t hold in the real world, but the main reason they don’t hold is the tax subsidy for debt”

    NO! For banks, besides tax considerations, the Modigliani-Miller Theorem is absolutely inapplicable; since it does not consider the value of the support society (taxpayers) explicitly or implicitly give the holders of bank debt. If a bank has 100% equity then all risk falls on the shareholder and the societal support is 0. If a bank has 5% equity and 95% debt then society contributes a lot to the party.

    Frankly, like in Europe, where some banks were leveraged about 50 to 1, and rates on bank deposits are still low, who on earth can one even dream to bring the Modigliani-Miller Theorem into the analysis?

    And the fluctuating societal support, is one of the main reasons behind the argument I have been making for over a decade, about how credit-risk adjusted capital requirements for banks distort the allocation of credit. Regulators are telling the banks: If you lend to what is perceived as safe, like to the AAArisktocracy, then you are allowed to hold less capital, meaning leveraging more, meaning you will receive more societal (taxpayer) backing, than if you lend to a risky SME.

    And so of course, if you increase capital requirements which reduces the leverage, banks will get less taxpayer support… ergo lend less and at higher interest costs. Would that be bad for the economy? Of course it would keep billions out of the economy (it already happens) especially while business models are adjusted and bank capital increased. But that austerity ☺ (less societal support spending) though it would hurt would not necessarily be bad… what is really bad for the economy are the different capital requirements for different assets… since that stops bank credit from being allocated efficiently.

  20. Mr. Kurowski,

    As is the case with fuel subsidies, I think both progressives and free markets defenders have largely reached consensus that should society wish to assist a certain target group, it is best to do so directly rather than through distorting schemes and middlemen. Any lender (whether the FED, a wholesale bank, or a retail bank) ties to minimize risk, often by requiring collateral, proof of assets or of income streams. Given that banks are given a number of privileges including access to the discount window, it seems odd to argue that the government should not be able to set requirements on those banks in terms of equity cushion similar to the requirements those same banks put on their own customers.

  21. Externality you write: “it seems odd to argue that the government should not be able to set requirements on those banks in terms of equity cushion similar to the requirements those same banks put on their own customers.”

    And you provide your own answer with “similar requirements”. Both banks and regulators are basing themselves on the same risk, namely bank borrowers’ perceived credit risk… and any perceived risk, no matter how perfect it has been perceived, is wrongly cleared for if excessively cleared… and that distorts!

    Suppose you had two nannies: If you averaged the risk aversion of your nannies you might be allowed to go out and play on the garden. If instead the risk aversion of both your nannies were added up, you would never see the sun. Get it?

    The risk regulators should worry about is the risk banks do not know how to manage the perceived risk of the clients… the capital requirements for banks are to cover for “unexpected losses” and, you do not do that, basing it on what is giving you the “expected losses”

    There has never ever been a mayor bank crisis that has resulted from excessive exposures to what was ex ante perceived as safe. These have always resulted from excessive exposures to what was ex ante considered as safe… like the AAA rated securities…therefore what should most scare regulators is not what is perceived as risky but what is perceived as safe, and might not be.

    Externality you write: “it is best to do so directly rather than through distorting schemes”

    Precisely, the use of portfolio invariant credit-risk weighted capital requirements for banks, is as distorting as schemes can be.

  22. Per, If even one person of a society put deposits into a bank, they LOWER the reserve ratio, if many contribute it can go to possibly zero should the stakeholders have leveraged equity which suddenly can’t be liquidated in a crisis. Rated securities only remain AAA if the cost of maintaining such security is low over a long, extended period of time.

    Example: Once an A student, not always an A student in the real world. An A person who dies, eventually becomes someone else’s ABC person(not knowing when part B actually arrived), as to a perpetual hand me down the A’s or their hell to pay, type person, which is what we currently have now. Instead denial becomes the main course and we divvy up the remains, it’s just not so much fun once we become the remains, that could be BB serving to go with your A servicing.

  23. I am not really sure at what you are hinting to but…

    If you, with regulations, make finance easier and cheaper for the AAA rated than what it should have been in the absence of those regulations then, one way or another, too much credit will flow to that AAA rated which will, sooner or later, not make it worthy of such rating…

    Or…tell me one bank exposure deemed “risky” that has caused disasters?

  24. The A student only becomes a D student because the D students passed a fiat law (no metadata required) rating themselves as A students who would always have a mommy taxpayer held hostage through brute force that they can shorn.

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