The previous excerpt for Chapter 12 discussed “nibbling the edges” as the current, weak reform of banking
Editor’s Note: This is the next in a Continuing Series of Articles by Joe, as excerpted from his Book; “Banking on Failure” co-authored by Laurel McDevitt.
Option #2: Dramatic Change Inside the Box
Admati and Hellwig propose that governments and regulators should require much higher capital levels for banks.[1] Stripping away worthwhile discussion on the nature of bank regulation, conflicts of interest, and deliberate and accidental confusion, the Admati-Hellwig thesis is easy to state: banks should hold common equity equal to 20-30% of total assets.[2] This proposal is far more stringent than Basel III since it references total assets rather than risk-weighted assets and since Basel III does not require common equity of more than 10% of risk-weighted assets.[3] Since risk-weighted assets are typically 30-60% of total assets,[4] the Admati-Hellwig capital proposal of 20-30% of total assets provokes debate and disagreement.[5]
An immediate, simple, and valid criticism of Admati-Hellwig is that the quantitative specification of 20-30% of total assets is contrived. There is no derivation or argument for this broad range other than appeal to history with the claim that this 20-30% level is typical of banks at the beginning of the twentieth century. (As just one comparison, our figure 8-2 of chapter 8 shows that the Bank of England equity capital in 1870 is 33% of total assets.) Since banking and the global economy now differ greatly from those of earlier centuries, historical precedent is not persuasive.
Our view is that the Admati-Hellwig proposal does lack foundation, but the larger point remains valid. The best argument, unfortunately, is criticism of the status quo. To put it informally, bankers and bank regulators claim that a proper bank equity level is 3% of total assets.[6] Yet this result is absurd and offends one’s common sense.[7] Banks with such thin equity survive from year to year due primarily to the perception of government support. Since the purpose of bank reform is to eliminate or, at least greatly reduce, government support, banks should have sufficient equity for stand-alone survival.
Thus, even though the 20-30% specification is arbitrary, we consider the Admati-Hellwig capital requirement to be far more appropriate than those of the Basel III “nibble the edges” approach. This higher capital level feels right and we expect that bank stand-alone credit strength would improve markedly. Bank regulators and bankers argue in response that bank funding cost will increase and, therefore, there will be fewer loans and higher yields for the banks’ borrowers. In other words, the regulators and bankers claim that raising the capital requirement for banks will hurt the banks, the borrowers, and – by extension – the entire economy.[8]
Ultimately, we concur with the Admati-Hellwig view that the cost of increasing bank capital to the economy is minimal relative to the benefit of establishing much safer banks. Unlike Admati-Hellwig,[9] we do not consider the trade-off to be a “free lunch” in which bankers’ and regulators’ fear and concern for impact on bank lending is baseless. Though not necessary in theory, some banks may well reduce lending to meet the elevated capital standard. Bank shareholders may not reduce their return targets wholly in line with reduced risk.[10] Bank creditors are unlikely to demand precisely the lower yields that theory might imply. All in, we do expect borrowers will find somewhat higher yields on bank loans when the banks have much lower leverage. Yet not only is this cost reasonable, it is also appropriate. Governments and bank regulators should not seek to subsidize or otherwise control bank lending rates.
For our “Dramatic Change Inside the Box” option, we also stipulate a large increase in the bank reserve requirement. For example, instead of requiring reserves of 10% of demand deposit liabilities in the U.S.[11] or 1% in the Eurozone,[12] banks should hold 30-40% reserves. Our only basis for this otherwise arbitrary range is Bagehot’s statement that the Bank of England held 30-50% in reserves circa 1870.[13] Reserve levels are much lower than 30-40% in the modern banking era due to the existence of (government) deposit insurance and lending. To lessen the dependence of banks on government, then, it is sensible for banks to hold reserves in sufficient quantity to give the perception and reality (?!) that government support is not necessary.
The disadvantage of this proposal to increase the minimum capital and reserve requirements in such large steps is simply that the paradigm remains unchanged. Banks would still be part of government since deposit insurance, central bank lending, bailouts, and extensive regulation and control are still present. Taxpayers remain at risk. While the banks are no longer “junk” under this option, there is no true quantification of the level of direct and indirect expected loss of the government support.
Yet these disadvantages – that nothing changes except for two simple criteria pertaining to capital and liquidity (reserves) – also provide an advantage. It is politically conceivable that this option could win support. Gaining approval for drastic change is always challenging. Yet this option would leave in place the roles and responsibilities of all institutions and people. Clearly, when showing “reform” to the voters, the bureaucrats and bankers will not advertize “don’t worry, none of us are being displaced or overly inconvenienced by these adjustments.” This proposal ruffles feathers without plucking them. Bankers and regulators will fight these inside-the-box capital and liquidity amendments, but they will not fight to the death.
The next excerpt for Chapter 12 will discuss a more extreme – but also more appropriate – reform for banking.
[1] A. Admati and M. Hellwig, The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About It, Princeton University Press, 2013.
[2] Id. In this discussion we take “assets” to mean the balance sheet assets plus the equivalent “assets” of off-balance sheet risk exposures.
[3] See again figure 3 of M. Auer and G. von Pfoestl, “Basel III Handbook,” Accenture, 2012, in which “capital conservation buffer” and “countercyclical capital buffer” would consist of common equity.
[4] See, for example, figure 5 of V. Le Leslé and S. Avramova, “Revisiting Risk-Weighted Assets,” IMF Working Paper WP/12/90, 2012.
[5] See, for example, M. Folpmers, “The Big ‘Capital’ Debate: Economists vs. Bankers,” Global Association of Risk Professionals FRM Corner, June 12, 2014.
[6] See section 4.1 of M. Auer and G. von Pfoestl, “Basel III Handbook,” Accenture, 2012, in which this minimum equity ratio of 3% may become a discretionary rule of the regulators.
[7] In chapter 4 and in other places, we’ve noted the high leverage of typical banks. With the exception of government support, there is no compelling explanation for the need or safety and soundness of such high leverage. In her book Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself, Free Press, 2012, Sheila Bair expresses both her strong view that banks should greatly reduce leverage and her distrust of “risk weights” and banks’ quantitative model calculations of their own risk.
[8] See, for example, P. Angelini et al, “Basel III: Long-term impact on economic performance and fluctuations,” BIS Working Paper No 338, February 2011. The authors, employees of the global regulator Bank for International Settlements, claim that each 1% increase in bank capital requirement “causes a median 0.09 percent decline in the level of steady state output.”
[9] In addition to A. Admati and M. Hellwig, The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About It, Princeton University Press, 2013, see also A. R. Admati, P. M. DeMarzo, M. F. Hellwig, and P. Pfleiderer, “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Socially Expensive,” Stanford University Graduate School of Business, 2013.
[10] See, for example, M. Baker and J. Wurgler, “Do Strict Capital Requirements Raise the Cost of Capital? Bank Regulation and the Low Risk Anomaly,” August 2013. The result of bank shareholders “not reduc[ing] their return targets” is merely a drop in market value of bank equity. While negative for the shareholders, this “regulatory risk” is inherent to all investments in bank equity.
[11] See, for example, Appendix VII of S. Gray, “Central Bank Balances and Reserve Requirements,” IMF Working Paper WP/11/36, February 2011.
[12] See, for example, https://www.ecb.europa.eu/mopo/implement/mr/html/calc.en.html
[13] See chapter 2 of W. Bagehot, Lombard Street – a Description of the Money Market, Public Domain book, circa 1870.
