Do large banks really need more capital?
The Group of 20 finance ministers have agreed to new, increased capital requirements for banks "that would force many institutions in Europe to raise tens of billions of euros in capital in the coming months," the Financial Times reports. Reading through the recent statements by Treasury Secretary Tim Geithner and former Fed Chairman Alan Greenspan last week, we see a lot of references to demanding more capital be held by banks and that this will somehow make the entire financial system more stable.
Yet missing from the discussion is any meaningful acknowledgment 1) that it was the activities of banks, not their capital levels, that caused the financial crisis and 2) that larger banks as a group do not have the earnings power to support higher capital levels, at least capital provided by private investors. The implication of the G-20 announcement is that larger banks must be government sponsored entities or "GSEs."
To us, there needs to be a recognition by the G-20 that large, complex banks probably cannot raise and/or generate internally sufficient capital to appreciably increase capital levels at the same time that we are limiting their earnings via "reforms." But first let's consider the role of activities, not capital, in the unfolding of the current crisis.
If you really examine the collapse of Lehman Brothers and Bear, Stearns & Co., in both cases the firms had more than adequate capital, at least as governed by the marketplace. Citigroup (NYSE:C) too had levels of capital that, while below peer, were still in the right neighborhood. But in each case, it was the risk-taking activities of these banks that made whatever capital they had in place irrelevant -- often by an order of magnitude or more. If you doubled the capital of Lehman or Bear or WaMu, for example, would it make the financial system less risky? Would these institutions have survived? We submit that the answer to both questions is no.
One of the key issues that global regulators and their political leaders still don't seem to understand is that while the crisis that began in 2007 did start in the market for non-bank finance, much of the market was sponsored by the banks themselves. In the world of off-balance sheet or "OBS" vehicles and OTC derivatives, the effective leverage on the capital of banks and non-bank dealers was infinite and still remains today far higher than official capital ratios suggest. More than two years ago, when players such as New Century Financial and others started to collapse, the pyramid of OBS securitizations, many of which were financed short-term via repurchase agreements, came unwound. No reasonable amount of capital that markets would voluntarily provide could have prevented this eventuality.
In an interesting paper by Gary Gorton and Andrew Metrick, both of Yale and NBER, "Securitized Banking and the Run on Repo," the authors argue that it was an 1907 style run on securitization that served as the catalyst for the crisis: "The current financial crisis is a system-wide bank run. What makes this bank run special is that it did not occur in the traditional-banking system, but instead took place in the "securitized-banking" system. A traditional-banking run is driven by the withdrawal of deposits, while a securitized-banking run is driven by the withdrawal of repurchase ("repo") agreements," the authors argue.
The simple explanation is that because Bear and Lehman were not part of the "bank" club, these firms failed. Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) were saved only via extraordinary efforts by the Fed and conversion into ersatz banks. But the wave of selling and demands for cash and collateral that almost destroyed all of the non-bank dealers was a function of confidence, not capital. And the same wave of selling and collateral demands would have destroyed the largest commercial banks too were it not for the extraordinary actions by the Fed to essentially float the entire rancid corpus of private label securitization.
As Gorton & Metrick argue:
What happened is analogous to the banking panics of the 19th century in which depositors en masse went to their banks seeking to withdraw cash in exchange of demand and savings deposits. The banking system could not honor these demands because the cash had been lent out and the loans were illiquid, so instead they suspended convertibility and relied on clearinghouses to issue certificates as makeshift currency. Evidence of the insolvency of the banking system in these earlier episodes is the discount on these certificates. We argue that the current crisis is similar in that contagion led to "withdrawals" in the form of unprecedented high repo haircuts and even the cessation of repo lending on many forms of collateral.
To us, making financial regulation effective again must start with a discussion of limits on risk taking activities by banks, particularly the use of OBS vehicles for securitization, the very non-bank OBS vehicles that now pollute the Fed's balance sheet. The FASB rule requiring the repatriation of all OBS vehicles back onto the balance sheets of the sponsor banks at the end of this year will start that process, but it will also illustrate that the problem is the effective leverage employed by banks, not static measures of capital. Instead of talking about more capital, the G-20 finance ministers should be focused on banks taking less risk.
Unless and until the leaders of the G-20 industrial nations are ready to return to deterministic limits on the activities of banks, systemic risk will remain a problem no matter how much "capital" is raised. For example, former Chairman Greenspan is dead wrong when he calls the financial crisis a "once in a century" event. If you allow banks to continue to traffic in OTC derivatives and structured assets, then the only certainty is that the present systemic crisis will become the norm, not a "rare event" as Chairman Greenspan asserts - and rather pathetically, in our view.
The second aspect of this discussion about bank capital that the leaders of the G-20 industrial nations must recognize is that risk-adjusted returns for larger commercial banks have been falling in the US for almost a decade. Even with the supra-normal nominal returns earned by some larger banks during the mortgage bubble, the overall trend measured via the RAROC calculated by The IRA Bank Monitor in our Economic Capital ("EC") model has been down, with less and less diversity observed among bank business models. We discussed this trend last year in The IRA, "Talking About RAROC: Is "Financial Innovation" Good for Bank Profitability?" last June.
During the peak of the financial bubble, nearly one-fifth of the earnings in the S&P 500 came from financials. Today the figure is half that and declining. As we remind subscribers of the IRA Advisory Service every chance we get, the forward ROE for banks is likely to be far lower over the next five years than it was over the past decade. Thus we have to wonder how the G-20 leaders expect banks to raise massive amounts of new equity at a time when they are going to be far less profitable and facing higher near-term credit costs, both individually and as an industry, than at any time since the 1980s. The IMF projects that while loan losses on US bank balance sheets may not reach the 5% seen in the 1930s, losses rates could peak near 4%, a rate that is still catastrophic. A 4% loss rate is close to 3x 1990s level loss rates, this vs. the 2x 1990 loss rate peak projected by IRA.
We view the current "debate" within the G-20 about bank capital as largely irrelevant in financial terms but very significant for the markets. Neither Secretary Geithner not his counterparts within the G-20 seem to understand the precarious situation that is still facing the largest global financial institutions. Let's take a look at JPMorganChase (NYSE:JPM), which we downgraded to a "negative" outlook last week in The IRA Advisory Service, using the EC model in The IRA Bank Monitor as a means of illustrating the problem.
As of Q2 2009, JPM was rated "C" based on an aggregate Stress Index score of 2.0 vs. 3.1 for the industry as a whole (1995=1). The Banking Stress Index is a quarterly stress test survey of all FDIC insured banks. JPM has parent level tangible common equity of 5.42% and bank-only TCE of 5.6%. While the bank units of JPM cumulatively have $114 billion in Tier One Risk Based Capital, the EC calculated for JPM's bank units by The IRA Bank Monitor is $474 billion or 4x the bank's regulatory capital. The RAROC calculated for JPM is just 0.148% vs. a nominal ROE of 5% at Q2 2009.
By the way, users of the consumer and professional version of The IRA Bank Monitor may view the detailed EC analysis for JPM and other banks for Q2 2009.
If the G-20 finance ministers get their way and force JPM to increase its Tier 1 RBC to say $250 billion, that implies that ROE and EPS would be more than cut in half. Does this sound like an attractive investment proposition? More, if anything like the present reforms on OTC derivatives being proposed in the EU and US become law, the earnings and returns for JPM and all large banks will likely fall further from levels observed during the past five years -- even with no regulatory capital increase mandated by the G-20.
So here's our question for Secretary Geithner, Chairman Greenspan and the G-20 finance ministers: Just how do you suppose that larger global banks will be able to raise and maintain additional capital if their earnings are falling and their risk-taking opportunities are receding? The forward model for banks under the G-20 world view looks a lot like a GSE with utility-type attributes that only a government would be willing to fund. And remember that lower leverage means these banks must take more risk in their trading activities to maintain ROE and EPS targets.
Indeed, the G-20 debate on bank capital may have the pernicious effect of causing investors to flee the large banks and the financials as a sector at just the moment in time when regulators are trying to boost capital and raise private funds for bank resolutions. While the end result of financial innovation was no surprise, the negative impact of the ill-informed G-20 discussions regarding bank capital adequacy may be very negative for financials in 2H 2009 and beyond.
Disclosure: None of the stocks mentioned in this comment are owned by any IRA employee.