Tag Archives: capital requirements

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.

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Skew

By James Kwak

There is a common phenomenon in legal disputes over the value of something, be it a company, a piece of land, or a person’s expected lifetime earnings. Each side hires an “expert” who produces an estimate based on some kind of model. And miraculously, every single time, the expert for the party that wants a higher number comes up with a high number, while the expert for the party that wants a lower number comes up with a low number. No one is surprised by this.

Yesterday, the Federal Reserve posted the results of the latest periodic bank stress tests mandated by the Dodd-Frank Act. For these tests, the Fed comes up with various scenarios of how things could go badly in the economy, and the goal is to see how banks’ income statements and balance sheets would respond. The key metrics are the banks’ capital ratios; the goal is to identify if, in bad states of the world, the banks would still remain solvent. If not, the banks won’t be allowed to do things that reduce their capital ratios today, like paying dividends or buying back stock.

For the most part, the results look pretty good: capital levels even under the severely adverse scenario should remain above the levels reached during the 2008–2009 crisis. (Of course, there are several huge caveats here. You have to believe: first, that the scenarios are sufficiently pessimistic; second, that the banks’ current financials are accurately represented; third, that the model is sensible; and fourth, that the capital levels set by current law are high enough.)

But there’s something else going on here. As part of the stress testing routine, each bank is supposed to do its own simulation of how it would respond to the scenarios specified by the Fed, using its own internal model. And—surprise, surprise!—the banks virtually uniformly predict that they will do better than the Fed.

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Missing the Point

By James Kwak

The Basel Committee’s recent decision to change the definition of the leverage ratio is bad news for two reasons.

There’s the obvious: A smaller denominator means less capital. The leverage ratio requirement says, in principle, that banks must have capital equal to at least X% of their total unweighted assets, where “assets” is supposed to include anything they hold that could fall in value. Take some bank that has some amount Y of traditional assets and other things that could fall in value, like derivatives positions. Then it has to have capital equal to X * Y / 100. If we take the exact same bank but decide to call Y some smaller number, say Z, then it can get bay with less capital. Less capital = more risk.

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What Does 9.5% Mean?

By James Kwak

This week, the Federal Reserve approved its final rule setting capital requirements for banks. The rule effectively requires common equity Tier 1 capital of 7 percent of assets (including the “capital conservation buffer”), with a surcharge for systemically important financial institutions that can be as high as 2.5 percent, for a total of 9.5 percent. That sounds like a lot, right?

If it sounds like a lot to you, it’s probably because (a) it’s higher than capital requirements before the financial crisis and (b) the banking lobby has been saying it’s a lot to anyone who will listen. But apart from some people thinking that higher is better and others thinking that lower is better, you rarely get any basis for understanding what the numbers mean.

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The Politics of Intellectual Fashion

By James Kwak

Update: See bottom of post.

For years now, Anat Admati has been leading the charge for higher capital requirements for banks, especially large banks that benefit from government subsidies, first in a widely cited paper and more recently in her book with Martin Hellwig, The Banker’s New Clothes. Admati’s great service has been clearing the underbrush of misunderstandings and half-truths so that it is possible to have a debate about the benefits of higher capital requirements. Yet even after all this work, the media (and, of course, the banking lobby) continue to repeat claims that are simply false or highly misleading.

In another effort to beat back the tides of ignorance, Admati and Hellwig have put out a new document, “The Parade of the Bankers’ New Clothes Continues,” which catalogs and addresses these claims. In the simply false category, the most common is probably that capital is “set aside”; in fact, banking capital is assets minus liabilities, and the capital requirement places no restrictions on what a bank can do with those assets.

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Restoring The Legitimacy Of The Federal Reserve

By Simon Johnson

The Federal Reserve has a legitimacy problem. Fortunately, a potential policy shift is available that offers both the right thing for the Fed to do and a way to please sensible people on both sides of the political spectrum: raise capital requirements for megabanks.

As the election season progresses, Republican politicians are increasingly criticizing the monetary policy of Ben Bernanke and his colleagues on the grounds that they are exceeding their authority, particularly by buying assets and trying to lower interest rates in what is known as “quantitative easing.”

There is growing concern in Republican circles that the Fed is tipping the election toward President Obama, and Mitt Romney repeated unambiguously in August that he would not reappoint Mr. Bernanke (a Republican originally appointed by President George W. Bush).

At the same time, a significant number of people on the left of American politics are concerned about how the Fed acted in the period leading up to the crisis of 2008 – blaming it for a significant failure of regulation and supervision – and about how much support it currently provides to big banks. Continue reading

Two Cakes

By James Kwak

Eric Dash of DealBook reports on the latest stress tests conducted by the Federal Reserve, which apparently went swimmingly, at least for some of the healthier banks. I have no independent basis on which to assess the accuracy of those test results, so I won’t.

What I did notice is that JPMorgan Chase and Wells Fargo are using the green light from the Fed to start buying back stock: $15 billion for JPMorgan, 200 million shares (about $6 billion) for Wells. Does something seem wrong with this picture to you? Me, too.

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Required Intellectual Capital

By Simon Johnson

At one level, the pursuit of higher and more robust capital requirements for banks is not going well.  The US Treasury insisted, throughout the year-long financial reform debate, that capital should be the focus – increasing the loss-absorbing buffers that banks must carry – and that they (and other regulators) needed to negotiate this is through the Basel Committee process.

But Basel has some under great pressure from the banking lobby, which argues that any increase in capital requirements would limit lending and slow global growth (see this useful background by Doug Elliott).  The Institute of International Finance (IIF) – a lobby group for big banks – issued an influential “report” along these lines and the European stress test results strongly suggest that Euroland politicians do not want to press more capital into their financial system – “just enough” would be fine with them.

However, at another level – in terms of the analytical consensus around these issues – there is a great deal of progress in the right direction.  In particular, an important new paper by Samuel Hanson, Anil Kashyap, and Jeremy Stein, “A Macroprudential Approach to Financial Regulation” pulls together the best recent thinking and makes three essential points.  (This is a nontechnical paper written for the Journal of Economic Perspectives – it’s a “must read” for anyone interested in financial sector issues but requires some effort and a little jargon does creep in.) Continue reading

The Mystery of Capital

By James Kwak

So the dust has settled on the Senate bill, and it remains studiously vague about capital requirements — no hard leverage cap, for example. This is what the administration wanted, for two reasons: first, they claim that regulators need ongoing flexibility to modify capital requirements; second, they claim that they need flexibility to negotiate a uniform international agreement.

There is one thing in there that is controversial enough to get the attention of the bank lobbyists: the Collins Amendment, which Mike Konczal has written about here. The main provision of the amendment is that whatever capital requirements apply to insured depositary institutions (banks), they also have to apply to systemically important financial institutions, including at the holding company level.

Sheila Bair of the FDIC is in favor of the amendment, on the argument that bank holding companies should not be able to evade capital requirements that are imposed on their subsidiary insured banks; she doesn’t want to regulate the depositary institutions but have all her work rendered irrelevant because the holding company collapses, triggering a mess of cross-guarantees.

This seems entirely unobjectionable, but as Konczal points out, the real threat to the banks is that it makes it harder for them to engage in financial engineering on the holding company level to evade capital requirements. According to the Wall Street Journal, not only the banks, but also the administration itself is planning to try to kill this amendment (at this point, in conference committee).

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Capital Requirements Are Not Enough

By Simon Johnson and James Kwak, authors of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (Pantheon, 2010).

The number of important people expressing serious concern about financial institutions that are too big or too complex to fail continues to increase. Since last fall, many leading central bankers including Mervyn King, Paul Volcker, Richard Fisher, and Thomas Hoenig have come out in favor of either breaking up large banks or constraining their activities in ways that reduce taxpayers’ exposure to potential failures. Senators Bernie Sanders and Ted Kaufman have also called for cutting large banks down to a size where they no longer pose a systemic threat to the financial system and the economy.

To its credit, the Obama administration recognizes the problem; according to Treasury Department officials, addressing “too big to fail” is one of the central pillars of financial reform, along with derivatives and consumer protection. However, the administration is placing its faith in technical regulatory fixes. And, as Andrew Ross Sorkin emphasizes in his recent Dealbook column, they see increased capital requirements as the principal weapon in their arsenal: “[Treasury Secretary Tim] Geithner insists that if there is one change that needs to be made to the banking system to protect it against another high-stakes bank run like the one that claimed the life of Lehman Brothers, increasing capital requirements is it.”

(Brief primer: Capital is money contributed by a bank’s owners–conceptually, their initial capital contributions plus reinvested profits–that does not have to be paid back. Therefore, it acts as a buffer to protect a financial institution from defaulting on its obligations as the value of its assets falls. The more capital, the less likely a bank is to fail. The more capital, however, the lower the institution’s leverage, and hence the lower its profits per dollar of capital invested–which is why banks always want lower capital requirements.)

Don’t get us wrong: we think that increased capital requirements are an important and valuable step toward ensuring a safer financial system. We just don’t think they are enough. Nor are they the central issue. Continue reading

Volcker, Warren, and Kaufman: There Must Be New Law

 By Simon Johnson, (13 Bankers, out tomorrow)

Some people at the top of the administration begin to understand that it makes both economic and political sense to impose binding constraints on our largest banks.  But even the clearest thinking among them still has a problem – breaking up banks seems too much at odds with the way they saved these same banks in 2009.  At best, this would be most awkward for the individuals involved on all sides.

“We’ll achieve the same general goal by imposing capital requirements that increase with the size of the bank” (not an exact quote) is the administration’s latest whispered idea, and in principle this has some appeal.  If done properly, this could level the playing field – and therefore should be supported politically by small banks.  By increasing the buffer against future losses, it would put in place greater protection for taxpayers against too big to fail (TBTF) institutions.  And it would push TBTF firms to break up if they really have nothing better than cheap funding – based on implicit government subsidies – to support their continued existence.

But this “let’s do it with capital requirements” proposal is deeply flawed and completely unacceptable.  From different perspectives, Paul Volcker, Elizabeth Warren, and Ted Kaufman all agree, we cannot rely on our existing regulations (and regulators).  We need new law. Continue reading

The Importance of Capital Requirements

Arnold Kling of EconLog has done the hard work of setting out his theory of the financial crisis and what we should learn from it in a fifty-page but highly readable paper available here. I have some quibbles but think it is  worth a read.

Here are the causes of the crisis in one table:

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The Real Choice on Too Big to Fail

Gillian Tett has an article criticizing the idea that CoCos — contingent convertible bonds — will solve the “too big to fail” problem. (And yes, she calls it “too big to fail,” even though Gillian Tett of all people understands what interconnectedness means.)

Contingent convertible bonds, a.k.a. contingent capital, are the latest fad to hit the optimistic technocracy in Washington and London. A contingent convertible bond is a bond that a bank sells during ordinary times, but that converts into equity when things turn bad, with “bad” defined by some trigger conditions, such as capital falling below a predetermined level. In theory, this means that banks can have the best of both worlds. They can go out and borrow more money today, increasing leverage and profits (which is what they want). But when the crisis hits, the debt will convert into equity; that will dilute existing shareholders, but more importantly it means the debt does not have to be paid back, providing an instant boost to the bank’s capital cushion. In other words, banks can have the additional safety margin as if they had raised more equity today, but without having to raise the equity.

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Was The G20 Summit Actually Dangerous?

It is easy to dismiss the G20 communique and all the associated spin as empty waffle.  Ask people in a month what was accomplished in Pittsburgh and you’ll get the same blank stare that follows when you now ask: What was achieved at the G8 summit in Italy this year?

Perhaps just having emerging markets at the table will bring the world closer to stability and more inclined towards inclusive growth, but that seems unlikely.  Should we just move on – back to our respective domestic policy struggles?

That’s tempting, but consider for a moment the key way in which the G20 summit has worsened our predicament. Continue reading