Bank Capital: A Looming Problem

By Simon Johnson

The Obama team’s plans are big and bold on key dimensions. The fiscal stimulus will be one of the largest ever in peacetime. We don’t yet know how much support there will be for a housing refinance initiative, but there is no question that the proposal will be huge.

But in this mix the lack of serious discussion (yet) of the need for new capital in the banking system is striking. It could be, of course, that reports on the lack of capital have been greatly exaggerated. And it could also be that a detailed assessment of the capital injections so far might indicate they have had less effect than previously expected - although you have to think about the counterfactual, what would the situation be now without these capital injections?

Most likely, the strategic thinking is along three possible lines here.

1) No more capital is needed because the fiscal stimulus will be large enough to turn around the economy, bringing back growth and gradually steepening the yield curve (so banks can go back to making money the good old-fashioned way: borrow short, lend longer). This is a plausible approach, but risky. There is a great deal that can go wrong or at least delay the positive effects of a big fiscal push, particularly in the current global economic environment - see my piece on Forbes.com today.

2) If more capital is needed at any point, it can be provided on the same sort of terms that Citigroup received in November. This seems dubious because I would expect a political backlash if there is an attempt to repeat or scale up this deal. The terms were simply too unfavorable to the taxpayer. And we should probably now move beyond relying on weekend rescues of major financial institutions; too much can go wrong under that kind of pressure.

3) If more capital is needed, there is a plan, but it is secret for now. This might have some appeal, in the sense that any plan would be controversial and could distort incentives. But Congress would surely appreciate knowing at least the potential scale and strategic direction for bank recapitalization in advance -- after all, Mr. Paulson’s surprise request to them in September did not go down well initially and did not work out well later. Any sensible plan would presumably involve the commitment of some hundreds of billions of dollars. This would be an investment on which the government can earn a good return, but more details in advance on potential deal structures could help us understand exactly the value proposition for the taxpayer.

Some proposals -- after we saw what happened at Citigroup (C) -- for recapitalizing the banking system are here. Our approach may not be the answer, and I understand why many on Wall Street would prefer to do things differently. But I do think we need more debate around a plan for recapitalization contingencies, and this should be done sooner rather than later.

Comments

[Chris B:]

I would be interested to know how much cash the banks are hoarding in excess of their reserve ratio. If we are just beefing up balance sheets with cheap loans, and not persuading banks to lend, then perhaps a consumer-driven stimulus would be more effective than the trickle-down approach of shoving money into bank coffers. If consumers are finally reverting back to the mean in terms of the savings rate (now about 0%, historically near 10%) or deleveraging from historically high household debt, we will probably just have to let it take its course.

2008 Dec 23 05:09 PM

[jepittman:]

Banks are holding approximately $1Trillion (yes, TRILLION) in excess reserves (according to Tony Crezenzi of Miller Tabak) with virtually NO yield available in bonified AAA short term securities. The ONLY option the Federal Reserve is leaving the banking industry to earn a return above theit cost of funds is to LEND to qualified borrowers. The problem is hardly lack of capital. The Fed has long since seen to that. The problem is getting the banks to LEND. With short rates scraping bottom they now have no alternative but to lend unless they want to further degrade their balance sheets with losses. Look for banks to accellerate their sales teams' efforts to find good loans in the coming weeks and months.

2008 Dec 23 08:34 PM

[Asbytec:]

Wow, thanks Jep. The latest figures I saw were closer to $600bn. Does anyone know how much in terms of toxic debt they need to cover? I understand no one knows, and that's part of the problem hoarding solves.

As long as home prices fall, jobless claims rise, and banks hold toxic debt everyone, including banks, is (are) a credit risk. The banks have a tough decision. To lend into credit risk or not to lend and lose money. Either way, they lose this catch 22. Banks tend not to lend into falling asset values, and asset values won't stabilize until lending becomes readily available.

I am afraid Chris is right, it will just have to run it's course. Jep, I understand the Fed is trying to pry the banks into lending. I hope they succeed. (well, really I hope for a totally new banking system and money based on value. But that isn't gonna happen.) It could be over in a few months, or it might take longer to get back to business as usual.

Personally, I hope it runs it's course and banks and consumers deleverage a good bit, first. Let those fiat dollars evaporate a for a while. And before we enter another "Greenspan" bubble, let's get some tighter regulation on how much money can be made in the derivatives markets, this time. Keep the money supply under control with some investment transparency.

I suspect one thing is sure. Watch for a break in the credit markets before calling this recession done. Some say months. I think longer.

2008 Dec 24 05:17 AM

[Jason Rines...:]

Agree. Pump up SBA and loan it to entrepenuars. Conduct more SBA marketing to get more grey haired volunteers to drill numbers into there heads. Focus on energy, technology, biotech and higher education sectors. Upward mobility and innovations projects in other words. The banks provide the loan, the government underwrites 50%. Small business, (51% of our GDP), middle class given some job creation opportunities before the massive tax bill comes due. Banks have lots of M/A activities planned for 2009 and the funding to that end. Will they need further recapitlization afterwards? I am not sure either.


On Dec 23 05:09 PM Chris B wrote:

> I would be interested to know how much cash the banks are hoarding
> in excess of their reserve ratio. If we are just beefing up balance
> sheets with cheap loans, and not persuading banks to lend, then perhaps
> a consumer-driven stimulus would be more effective than the trickle-down
> approach of shoving money into bank coffers. If consumers are finally
> reverting back to the mean in terms of the savings rate (now about
> 0%, historically near 10%) or deleveraging from historically high
> household debt, we will probably just have to let it take its course.

2008 Dec 24 09:04 AM

[Chris B:]

Agreed big thinker,

From jep & asbytec's numbers, it sounds like government has ensured the solvency of the banks, which was job one. Perhaps any further spending should be directed towards things that will actually pay future dividends for the nation in exchange for the debt incurred.

Primary, technical, and higher education.
Energy independence and efficiency.
Infrastructure.
Disaster preparedness.
Public safety and health.
Drug abuse prevention and rehab.

This short list contains lots of small business / job creation opportunities in all industries. Most importantly, taxpayers would be getting something for their money instead of facilitating the mergers of banks into oligopolies that will eventually charge them higher fees or subsidizing Goldman Sach's derivitives trading desk.

2008 Dec 24 09:34 AM

[jepittman:]

Thankfully ALL prices of assets are not falling. Real estate is extremely local in price behavior. In many areas home prices have never declined. In others they have cratered. There is always a demand for credit and banks, given the right incentives, can and will adjust to the new conditions and make loans to qualified borrowers. Local bankers know their markets. If the incentives are right, lending should resume fairly quickly.


On Dec 24 05:17 AM Asbytec wrote:

> Wow, thanks Jep. The latest figures I saw were closer to $600bn.
> Does anyone know how much in terms of toxic debt they need to cover?
> I understand no one knows, and that's part of the problem hoarding
> solves.
>
> As long as home prices fall, jobless claims rise, and banks hold
> toxic debt everyone, including banks, is (are) a credit risk. The
> banks have a tough decision. To lend into credit risk or not to lend
> and lose money. Either way, they lose this catch 22. Banks tend not
> to lend into falling asset values, and asset values won't stabilize
> until lending becomes readily available.
>
> I am afraid Chris is right, it will just have to run it's course.
> Jep, I understand the Fed is trying to pry the banks into lending.
> I hope they succeed. (well, really I hope for a totally new banking
> system and money based on value. But that isn't gonna happen.) It
> could be over in a few months, or it might take longer to get back
> to business as usual.
>
> Personally, I hope it runs it's course and banks and consumers deleverage
> a good bit, first. Let those fiat dollars evaporate a for a while.
> And before we enter another "Greenspan" bubble, let's get some tighter
> regulation on how much money can be made in the derivatives markets,
> this time. Keep the money supply under control with some investment
> transparency.
>
> I suspect one thing is sure. Watch for a break in the credit markets
> before calling this recession done. Some say months. I think longer.

2008 Dec 24 11:05 AM

[jepittman:]

One other point on banks holding bad assets: Many bad assets have already been written off and should not be an issue going forward. For questionable loans still on the books, the Fed has opened the discount window wide so these can be a source of liquidity also. Also keep in mind that a lot of loans gone bad will be renegotiated by lenders and at some point down the road result in a workout going back on the books at a positive valuation. This is not something to 'bank' on but it happens in every credit cycle. Although banking regulations require agressive writedowns of non-performing loans those loans are still loans, often with collateral, and in time works its way back to the banks' balance sheet.

2008 Dec 24 11:15 AM

[Chris B:]

If the consumer savings rate is reverting from 0% back to the long term mean of about 10%, and consumption is 70% of GDP, this reversion to the mean in itself would involve a 7% decline in GDP. Historically high levels of consumer debt make such a scenario very possible (as paying off credit cars and savings account deposits are both basically saving).

A 7% GDP decline in itself would result in high unemployment, loan losses, etc. However, we must also keep in mind GDP contributings from increased government spending and reduced imports. Depending on energy prices, this could result in only a 3% decline in GDP. Yet most households would be better off, as they would be paying off debt instead of creating it and we would be buying less useless junk such as most of what I'm getting for Christmas.

2008 Dec 24 02:06 PM

[morph366:]

As long as there are willing participants to load up on ten year Treasury debt with a two percent coupon and with benchmark yields close to zero there is no real reason to save. For US consumers who took out almost a trillion dollars of "wealth" in their homes to support their consumption binges, the change in GDP will come about, not from any increase in the marginal propensity to save and therefore indirectly to their marginal propensity to consume, but rather from the absence of usable collateral in their holdings to keep borrowing their way to prosperity

2008 Dec 25 08:30 AM

[a fat panda:]

Lack of capital? The banks are paying dividends, close to 30 billion this year alone. Dividends are by definition excess capital. The problem isn't capital, it is credit worthy customers. That is where the serious deficit is.

2008 Dec 25 11:02 AM

[peterthepai...:]

go fat panda...

2008 Dec 26 09:08 AM