The End of Our Banking System?

The American Banking System is one of the most regulated industries in America. Since 1935, banks have had to deal with regulations that no other industry has come near. So what went wrong?

Because of 1929, banking regulations were devised setting up minimal capital requirements. They established capital adequacy ratios in order to prohibit banks from lending more than 12 times their capital plus retained earnings.

But regulators did not take into account future inflation. So regulation forced banks to limit their lending to 12 times their inflation-eroded capital.
A 4% inflation rate multiplied by 12 reduces banks' lending capacity by 48% of their capital base. In a single year!

That is why banks have stopped lending; in 2008 and 2009 they are being forced to recall 2 billion dollars' worth of loans. In other years, retained profits mitigated this ludicrous bank regulation, but no bank has made a profit in 2008.

So brace yourself for 2009. The recession will be caused by bank regulation not for lack of it.

With today's capital base worldwide at around $200 billion, factor in a 4% inflation multiplied by 12, and you will discover that banks worldwide will be constrained to reduce loans outstanding to the order of $2 trillion in 2009 and 2010.

Due to these regulations set up as early as 1935, banks have over the years lost interest in lending per se, and have been forced to enter all other types of financial markets, such as derivative service fees, equity deals anything but straight plain-vanilla loans.

As a consequence banks have also lost interest in credit analysis, and America as a nation has lost its credit intelligence, whose effects can be seen today.

Credit training was once considered an important step in a young man's career, so much so that four Presidents of the United States started out as trainees at Dunn & Bradstreet, Lincoln, Grant, Cleveland and McKinley.

They learnt the Five Cs of credit analysis formula: Character, Conditions, Cash Flow, Capacity and Collateral - which became a subtle art. Today, credit is given by quantitative formulas, based on one single variable: Collateral.

Now answer this question: was this crisis caused by corporate greed and management bonuses, or by faulty legislation? Are we in the face of a credit crunch, illiquidity, or is there a regulation forcing banks to withhold credit?

It is frightening to realize that academics such as Milton Friedman, John Maynard Keynes and Ben Bernanke, all of whom wrote extensively about 1929 and banking regulation, should have overlooked such a simple regulatory mistake with such an impact on banks' lending ability.

Granted that inflation rates were low, and retained earnings of banks were high at the time, banks were allowed to grow though not at full speed. But in 1982, when inflation in the United States reached 20% over a two-year period, the effects were devastating.

Every single American bank had to recall practically 200% of their capital base, mainly from underdeveloped countries setting off one of those graders financial crises in the Third World.

Instead of changing banking regulations and allowing banks to adjust their capital bases to inflation, most economists once again blamed the banks, as in 1929, accusing them of having overextended themselves once again.

More bank regulations were called for, instead of correcting what must have been the most ridiculous and incoherent rule in economic history.

Forcing banks to erode their accounting capital base rather than reflecting the effects of inflation has slowly and inexorably destroyed the world's banks' lending capacity year after year.

Instead of a world debt crisis and IMF bailouts with stringent and recessionary economic policies for over indebted countries, had banks been allowed at that time to lend their inflation adjusted capital, they would have solved the debt problems on their own.

Not only were they prohibited from lending to Third World countries in order to maintain their debt level in real terms, banks were also forced to make bad debt provisions depleting even more their lending base.

Once again banks are required to make provisions and write-offs for having lent to poor people compounding once again the current financial crisis.

Just as we are doing today, economists in 1986 demanded even more stringent bank regulations, which became the Basel I and Basel II agreements. Rather than adjusting capital base to inflation, banks were compelled by these agreements to calculate risk-adjusted capital base eroded every year by the current rate of inflation.

Capital adequacy rules were originally designed to strengthen banks, but oddly enough, leading economists have totally failed to see that they have slowly and inexorably destroyed banking and lending capacity each year.

Credit departments were slowly replaced by complicated economic models, which, only now Alan Greenspan realizes were based on insufficient quantitative data. But he misses the point: there will never be sufficient data to be able to substitute the individualized scrutiny of a credit committee.

Banks have slowly lost their lending capacity to "financiers" like Mike Milken, who’re far from being financial whizzes, and were the beneficiaries of banking regulations that allowed them a field day.

Constrained as a lending institution, the deterioration of our banking system gave rise to an equity-based economy. Companies were not allowed anymore to leverage, and had to depend on volatile and expensive equity market.

This effectively crowded out small and medium companies from cheap financing, and paved the way for the big globalized corporations that have the power nowadays, producing in India and China to reduce costs.

We have slowly destroyed our credit intelligence, substituting it for credit ratings issued by three relatively small companies, which clearly are overwhelmed and are not prepared to do the job they have been forced to do.

None of the measures to correct this financial crisis has addressed the fact that the capital adequacy ratios and the accounting data are totally incorrect. The consolidated net equity of the banking system has been totally eroded by seventy years of US inflation, giving the impression that banks do not have enough capital to meet their credit demands.

Bear Stearns was sold for $200 million, and no one realized that only its central office building alone is worth more than $1.5 billion, but due to inflation this current value does not appear in its books.

What we see is another 'blame it on the banks' movement, which will only destroy  our banking system even more; will deplete our credit intelligence even more; will reduce even more the ability of small and medium companies in securing cheap loans supervised by a competent and experienced credit committee within full-fledged banking institutions, making loans the old fashioned way.

Capital adequacy rules were originally designed to strengthen banks, but oddly enough, leading economists have totally failed to see that they have slowly and inexorably destroyed banking and lending capacity each year.

Disclosure: Author holds positions in banking securities.

Comments

[investor88:]

Seems Stephen is advocating giving banks more freedom to lend, to increase leverage during crisis. I wonder if this is the right prescription as it would make them even more unstable from cash flow angle.

2008 Nov 09 08:38 AM

[who:]

Freedom to lend will or does not automatically increase leverage. Regulation and supervision leads to false pretense of cannot fail banks. Regulations and supervisions failed, which caused the failures in the banks.

As a depositor or a creditor would do business with bank that is highly leveraged - answer is probably no since the risks are high. Disclosure is the key.

Regulation meant that banks could increase their lending by using insurance against default to meet their regulatory requirements.

Reliance on the 3 rating agencies were total. Lack of credit control and relationship management are causes of the problems.

Proper regulations rather more or less regulation is required and full disclosure - no off the balancesheet activities should be allowed.

2008 Nov 09 01:18 PM

[Bill Herbert:]

Stephen - You are an utter fool.

The current crisis is one caused by recklessness, corruption, and a book a near-term profit at all costs mentality. It's the racketeering mentality, not inflation or too many regulations! What sheer nonsense.

I am surprised that people who think like you are gainfully employed. But I doubt that you will be for too much longer.

2008 Nov 09 06:21 PM

[Philip Gvinter:]

This article makes some outladish claims with no citation of sources which makes it fairly hard to believe. Also the mathematics of 4% inflation times 12 is not explained, I am assuming that this involves 12x leverage? Also where is the global capital base number of $200B coming from? That one seems like it was pulled out of thin air. I would also like to say that not giving a lack of transparency and even more importantly a lack of integrity it the originate-to-distribut... model (where originators knew they were originating garbage loans that would never be paid back but felt that the spreading of risk meant that they should not care as long as an investor was willing to buy) its just piece of the blame puzzle seems extremely silly.

2008 Nov 10 07:46 AM

[Vox Rationalis:]

I couldn't get past the 48% number early on. Fact is, banks consider inflation when setting interest rates. If they do it well, the effect of inflation is nil.

2008 Nov 10 09:31 AM

[monday1929:]

Inflation does not errode banks capital.

2008 Nov 12 01:35 PM

[Ferdinand E...:]

Let's see now. Grant finished West Point, after which he drank a lot of whiskey and at one time served in the war in Mexico. Later he left the army and became an unsuccessful leather dealer in Illinois. The Civil War saved him, and he ranks with Lee as the best general the US ever produced. But, as Alphonso Montoya might have said, I don't know nothing about no stinking Dunn and Bradstreet.

Of course, there are a lot of things that I don't know anything about. I guess that it's possible that at some stage of his career he put on a suit, tie and white shirt with a highly starched collar, and imbibed some wisdom at Dunn and Bradstreet, but whether he learned anything is highly uncertain. I'd check on his career if I were you Prof, because I seem to remember giving a lecture on Grant before I was expelled from infantry leadership school.

Professor Ferdinand E. Banks

2008 Dec 02 08:30 AM