Major Banks Likely to Get Reprieve on New Capital Rules
Posted by WARREN MOSLER on June 11th, 2011
The real problem is if you understand what a bank is, you wouldn’t be trying to use capital ratios to protect taxpayer money.
First, notice that the many of the same people clamoring for higher capital ratios have also supported ‘nationalization’ of banks, which means there is no private capital. So it should be obvious that something other than private capital is employed to protect taxpayer money.
Taxpayer money is protected on the asset side (loans and other investments held by banks) with lending regulations. That includes what type of investments are legal for banks, what kind of lending is legal, including collateral requirements and income requirements. That means if Congress thought the problem in 2008 was lax and misguided lending, to further protect taxpayer money they need to tighten things up on that side. And that would include tightening up on supervision and enforcement as well.
(Of course, they think the current problem is banks are being too cautious, but Congress talking out of both sides of its mouth has never seemed to get in the way before. Just look at the China policy- they want China to strengthen its currency which means they want the dollar to go down vs the yuan, but at the same time they are careful not to employ policy that might cause China to sell their dollars and drive the dollar down vs the yuan.)
So what is the point of bank capital requirements? It’s the pricing of risk.
With an entirely publicly owned bank, risk is priced by government officials which means it’s politicized, with government officials deciding the interest rates that are charged. With private capital in first loss position, risk is priced by employees who are agents for the shareholders, who want the highest possible risk adjusted returns on their investment. This introduces an entirely different set of incentives vs publicly owned institutions. And the choice between the two, and the two alternative outcomes, is a purely political choice.
With our current arrangement of banking being public/private partnerships, the ratio between the two is called the capital ratio. For example, with a 10% capital ratio banks have 10% private capital, and 90% tax payer money (via FDIC deposit insurance). And what changing the capital ratio does is alter the pricing of risk.
Banks lending profits from the spread between the cost of funds and the rates charged to borrowers. And with any given spread, the return on equity falls as capital ratios rise. And looked at from the other perspective, higher capital ratios mean banks have to charge more for loans to make the same return on equity.
Additionally, investors/market forces decide what risk adjusted return on investment is needed to invest in a bank. Higher capital requirements lower returns on investment, but risk goes down as well. But it’s not a ‘straight line’ relationship. It takes a bit of work to sort out all the variables before an informed decision can be made by policy makers when setting required capital ratios.
So where are we?
We have policy makers and everyone else sounding off on the issue who all grossly misunderstand the actual dynamics trying to use capital requirements to protect taxpayer money.
Good luck to us!
For more on this see Proposals for the Banking System, Treasury, Fed, and FDIC
Major Banks Likely to Get Reprieve on New Capital Rules
By Steve Liesman
June 10 (CNBC) — The world’s major banks may get a break from regulators and be forced to set aside only 2 percent-to-2.5 percent more capital rather than the 3 percent reported earlier, officials familiar with the discussions told CNBC.
News of the potential reprieve—which would affect major global banks such as JPMorgan , Citigroup , Bank of America , Wells Fargo , UBS and HSBC —helped stocks pare losses Friday afternoon.
The new rule, which would force the world’s biggest financial institutions to set aside more capital as a cushion against potential losses, is being imposed after the recent credit crisis nearly caused the collapse of the banking system.
The increased capital buffer would be in addition to a seven percent capital increase for all banks, which was negotiated at last year’s Basel III meeting.
The officials, who asked not to be named, made their comments after global banking regulators met this week in Frankfurt. The US has proposed a tougher three percent charge for big banks, but there has been pushback from some European nations, especially France. Negotiations are continuing.
The news comes after JPMorgan Chief Jamie Dimon rose in an Atlanta meeting this week and directly confronted Fed Chairman Ben Bernanke over the numerous new banking regulations, including a new surcharge for the biggest banks.
Officials say there is a more formal meeting in two weeks of regulators in Basel, Switzerland, where the actual percentage should be formalized as a proposal to global leaders.
Sources caution that the situation is still a moving target, with the U.S. apparently holding out for a higher global surcharge if other countries push lower forms of capital, other than common equity, to be used to meet capital requirements.
Earlier this week, U.S. Treasury Department Secretary Tim Geithner suggested that the higher the quality of capital, the lower the surcharge can be.
June 11th, 2011 at 5:15 pm
Disagree.
The purpose of equity capital is to provide first loss protection – period.
Risk and equity capital are analytically separate at the start of the relevant event.
Risk embeds ex ante scenarios for the transmission of ex post changes to capital – positive or negative – i.e. scenarios for the actual effect of internal capital generation.
The entire capital structure broadly defined – equity and all other forms of funding (including government backed funding) – must absorb the risk that is transmitted ex post to it (i.e. the actual return), according to the ranking terms of the entire capital structure.
A lower level of equity capital means a higher ex ante risk (i.e. volatility) to the expected return on it. That risk requires a higher expected return – i.e. the cost of equity capital is higher. There is no free lunch.
Poorly managed banks are obviously capable of becoming overleveraged, if not constrained, and may stretch in the same overall process to misprice (under-price) risk. But that’s bad management. It is not the normative relationship between risk pricing and capital structure. Such management risk is a key reason why higher capital ratios may be effective.
Properly run banks will not target the same return on equity with higher capital ratios – they will target lower returns, because the cost of equity capital will be lower (because the expected return is less risky (i.e. less volatile)). This assumes the same risk measurement, because risk measurement and capital allocation are analytically separate components of the risk/capital paradigm.
….
Lending regulations are formative constraints on the risk generated by banks.
But the issue is not lending regulations. It is the broader umbrella of regulations that covers both the measurement of risk and the allocation of capital to risk. Lending is just one big chunk of the risk issue.
The relationship between risk and capital is central. If you want a capitalist anchored system, you must define that relationship as central to the regulatory framework.
You can’t confuse that capital analysis with the alternative of a pure socialist system, largely because a detailed socialist paradigm for a workable banking system alternative is non-existent.
….
And the notion that a socialist’s second choice is higher capital ratios – that notion has no place whatsoever in the proper analysis of the relationship between risk and capital in a capitalist anchored system. It’s a random juxtaposition of confused thinking.
Reply
roger erickson Reply:
June 11th, 2011 at 5:57 pm
@JKH,
As an outsider to banking, this is mystifying.
1) once loans create reserves, how is lending ever capital restrained? In practice, isn’t it supposed to be credit-rating restrained?
2) once deposits are FDIC insured, how does capital constrain speculation by banks?
3) conclusion is that bank behavior is only constrained by public regulation?
i.e., on the regulatory side, not the liability side?
4) not clear that we want a “capitalistic” system (whatever that is, precisely); what we want even more is an adaptive system
5) with exit from the gold-std, didn’t the relationship between risk and capital move out of banks & to the Treasury-backed FED & FDIC combo? Since 1933 banks are supposedly licensed to focus on the relationship between credit-rating and return-on-public-purpose (meaning strategic return-on-strategy, which points up the added responsibility inherent in moving from a currency system based on static assets to one based on dynamic public initiative)
6) Your comments make me think that we can’t adapt without formally altering the stated mission of both the Treasury & FED.
Reply
WARREN MOSLER Reply:
June 11th, 2011 at 9:00 pm
start with a bank with 100 in capital and nothing else on its balance sheet.
if max allowed capital ratio is 10%, once the bank makes 1000 in loans and takes in 900 in deposits it has reached the legal limits of it allowed credit expansion.
that is, it’s not allowed to take on additional deposits, as that would drive the capital ratio below 10%
at that point, to further expand, it has to raise more private capital/equity.
it can only do that if it can offer the going rate of return for new capital.
Reply
beowulf Reply:
June 12th, 2011 at 4:07 am
@WARREN MOSLER,
if max allowed capital ratio is 10%, once the bank makes 1000 in loans and takes in 900 in deposits it has reached the legal limits of it allowed credit expansion.
Your “loan officers” (in the Mumbai call center,err, branch) sign up as funders on peer to peer lending sites, their weak sister competition is presumably lending at a 100% capital ratio.
http://www.lendingclub.com/public/steady-returns.action
that is, it’s not allowed to take on additional deposits, as that would drive the capital ratio below 10%.
Your “i-bankers” (same call center, different shift) then applies for venture funding on peer to peer investing sites to bring in more capital. Since your lending team is posting pharmaceutical company gross margins without any overhead (well there’s the hourly nut to the call center), The additional capital will flow in, allowing for more loans, rinse and repeat.
http://austinstartup.com/2010/04/microventures-offers-p2p-investment-platform/
All that’s missing is a peer to peer CBO site to hedge it all (your IT team can tackle that, do they even have call centers in China?). Oh yeah, and a Brazilian retirement team to keep your golden ejection seat ready for when the Feds finally determine which agency should have stopped you in your tracks. :o)
WARREN MOSLER Reply:
June 12th, 2011 at 10:34 am
i suspect the fdic and occ already limit lending to those types of borrowers, to protect taxpayer money, of course
MamMoTh Reply:
June 11th, 2011 at 6:30 pm
@JKH,
I would be a shame if Warren was wrong because I could understand his explanation.
Reply
WARREN MOSLER Reply:
June 11th, 2011 at 9:01 pm
:)
Reply
WARREN MOSLER Reply:
June 11th, 2011 at 8:56 pm
‘The purpose of equity capital is to provide first loss protection – period.’
yes, that’s the headline mainstream view, along with the rest of what you wrote.
So you are correct, as those determining ‘purpose’ think as you do.
Which is my point.
Currently bank regulation, etc. is being debated and implemented by those with that view, and the consequences follow.
With my view, one sees a different purpose for capital, etc.
“A lower level of equity capital means a higher ex ante risk (i.e. volatility) to the expected return on it. That risk requires a higher expected return – i.e. the cost of equity capital is higher. There is no free lunch.”
Yes, for a given asset, which is my point exactly.
Reply
JKH Reply:
June 11th, 2011 at 10:17 pm
@WARREN MOSLER,
don’t see how that can be your point; it doesn’t change the pricing of asset risk – the higher expected return on equity comes from the effect of higher leverage
and, the other way around:
“Banks lending profits from the spread between the cost of funds and the rates charged to borrowers. And with any given spread, the return on equity falls as capital ratios rise. And looked at from the other perspective, higher capital ratios mean banks have to charge more for loans to make the same return on equity.”
As I said, they don’t rationally seek the same return on equity – higher capital ratios reduce the cost of equity
Reply
JKH Reply:
June 12th, 2011 at 6:13 am
@JKH,
I should add that in a better regulated world, the insurance premium for government risk protection is a function of the strike price, or the moneyness of the option – i.e. the capital requirement. The insurance premium should be low enough to allow reasonable functionality for the capitalist anchor – meaning that capital requirements must be high enough. More generally, changes in capital requirements necessitate changes in the required economic insurance premium.
@MamMoTh,
hope that’s perfectly clear now
WARREN MOSLER Reply:
June 12th, 2011 at 10:20 am
so let’s say you’re allowed 1% capital ratio. If the loans are currently priced with a 3% net interest margin, that’s a 300% marginal roe. But if it goes bad, you only lose 1%, and the fdic loses the rest. (And you can diversify by owning shares in multiple banks.) So with actual losses expected to be maybe 1%, banking is insanely profitable well beyond that point of attracting capital. So market forces work to cause banks cut rates to increase market share which lowers returns down to that needed to attract capital.
now lets say capital requirements are 100%. The 3% net interest margin means returns on equity are only 3%. That may not be enough to attract capital, even though risk of loss is far lower. So banks would have to increase rates to attract new capital.
So what happened is that hiking capital ratios from 1% to 3%, caused rates to borrowers to go up for the same loan quality (yes, given all kinds of assumptions holding as well)
And note that the relation between capital ratios and risk adjusted returns for a given loan at a given spread is not a ‘straight line’, nor does it change linearly as net interest margins change and as perceived risk of each loan varies.
So back to my original point, capital ratios are a tool for adjusting the price of risk.
Art Reply:
June 12th, 2011 at 9:06 am
@JKH,
“Poorly managed banks are obviously capable of becoming overleveraged, if not constrained, and may stretch in the same overall process to misprice (under-price) risk. But that’s bad management.”
Seems to be a lot of bad bank managers out there (whose code word for poor management skills is “harsh competitive realities”).
Even the alleged good guys…
http://www.nytimes.com/2011/05/31/opinion/31nocera.html
…are be a bit shady:
http://dealbook.nytimes.com/2010/03/08/mt-banks-flight-plan-for-chief-executive/
Reply
WARREN MOSLER Reply:
June 12th, 2011 at 10:35 am
yes, hence my reference to supervision, which is critical
Reply
June 11th, 2011 at 7:37 pm
@roger erickson,
(I think you meant loans create deposits, whatever …)
“Credit ratings” (generated by agencies or the banks themselves) are part of the tool kit for the evaluation of asset risk. It’s a somewhat old fashioned term for credit risk assessment.
In any event, the credit risk that is evaluated determines the amount of capital that must be allocated to that credit risk. Banks literally assign pieces of their total capital position to the risk that is quantified across – not only all lending assets – but all risks of all types, including non-credit risks and operational risks related to deposit banking. ANYTHING that can potentially create a loss will be representable as risk and attract a capital requirement.
Again, the purpose of capital is first loss protection.
The amount of capital allocated depends on the macro paradigm for capital allocation rules (e.g. external regulatory plus internal supplementary) and the nature of the risk that requires capital support consistent with that paradigm.
The “macro paradigm” includes an aggregate “ratio” that is set according to policy, as well as a set of micro ratios according to various risk categories, which are constrained in summation to the macro ratio.
Capital is first loss protection. “Full deposit insurance” just means the FDIC is next/residual loss protection. Of course, not absolutely everything beyond capital is supposed to be insured in the normal environment, but this is not the most important point. The more important point is that regulation must establish the quantitative demarcation line between capital and the rest of the liability side of the balance sheet. That means a ratio must be defined. There’s no way around it.
And in particular, there is also no way around it in the case of the Mosler proposals as well. The bar must be set to define the first loss protection and any residual exposure. And no amount of asset discipline will preclude the possibility of residual loss exposure, however remote that is. If there is risk in banking assets at all, that risk must be borne in reverse order on the right hand side of the balance sheet, bottom to top. You can streamline banking and make it much lower risk, but somebody will have to make the macro prudential decision on bank capital guidelines.
The reason there’s no way around it is that capital is effectively an option on bank assets at a strike price equal to the value of the rest of the funding structure. The “moneyness” of that option is the loss protection that is afforded to the rest of the funding structure. Somebody must decide where to set that option strike price. It’s an unavoidable decision.
Setting that ratio is one part of macro prudential management of capital and risk in banking. The complementary part is setting the standards for risk measurement. In this regard, what Basle or anybody else must do is put “value at risk” in its proper place, which is well down the strategic hierarchy of quantitative bank risk management. It’s there, but it must be put in context. All of these disaster episodes since LTCM, including mortgages and CDOs, have essentially been debacles of variations on chronic value at risk myopia – letting the quantitative children run the shop, with judgemental adults abandoning their proper posts in banking.
Regulation is essential, but it’s not the only constraint on bank behaviour. Regulation sets boundaries. Banks still have choices within boundaries, which is what their shareholders are looking for them to do.
I said “capitalist anchored” system. I’d be interested to know if socialist nationalisers would do away with balance sheets. If not, what would those balance sheets look like? What would be the structure of the right hand side? But you know what – I know they don’t have an answer either way.
Reply
WARREN MOSLER Reply:
June 11th, 2011 at 9:06 pm
again, for me, close analysis of banking shows the public purpose is best served by using capital ratios to adjust the price of risk, as I’ve previously discussed,
rather than current practice of using capital ratios to protect taxpayer money as you so well outline, and for the reasons you outline.
think of what they are doing now is using a screw driver as a hammer, or something like that
Reply
roger erickson Reply:
June 11th, 2011 at 10:21 pm
@WARREN MOSLER,
> using capital ratios to protect taxpayer money
Then what is the FDIC for?
Reply
WARREN MOSLER Reply:
June 12th, 2011 at 10:23 am
the fdic is to insure deposits, as the liability side of banking (deposits and equity capital) has been shown to not be the place for market discipline, by both theory and practice.
if deposits are not insured, that means when you open a checking account you have to read the bank’s financials and determine if it’s safe enough to use. There is no such ability to do this, and every system that’s tried periodically goes down in flames.
June 11th, 2011 at 8:59 pm
Warren writes: “First, notice that the many of the same people clamoring for higher capital ratios have also supported ‘nationalization’ of banks, which means there is no private capital.”
These people supported ‘nationalization’ because there was no private capital.
We need to read this from Warren’s perspective :) as a small banker with limited capital yet seeing a huge opportunity? He could take advantage of that opportunity if he had regulators limiting the types of loans he made rather than those regulators limiting his lending based on capital.
I’d say any bank with less than a 50% private/public capital is socialist. In other words, we have more social capital than private capital being allocated by bankers.
Personally I support Warren in his desire to expand. I’d like to see a variable structure where small banks were allowed lower ratios and large banks, especially too big to fail banks, were required to have very high ratios.
Reply
June 11th, 2011 at 9:03 pm
Why does the community banking lobby seem so ineffective in pressing for a progressive agenda against big finance?
Is it every small bank’s dream to be swallowed by a big bank someday?
Reply
WARREN MOSLER Reply:
June 11th, 2011 at 9:11 pm
because they’re a bunch of opportunist entrepreneurs who don’t understand banking, don’t understand or care how the community banks are actually being disadvantaged,
but they are good at getting $ of of community banks to do the worthless lobbying.
Reply
Winslow r. Reply:
June 11th, 2011 at 9:52 pm
@WARREN MOSLER,
It seems you should be saying ‘public purpose’ is, at least, equally served by community banks as big finance and the funding structure should reflect that.
Intuitively, I’d go further and say public purpose is more served by community banks yet small bankers fail to capitalize on public goodwill towards small banks.
Reply
WARREN MOSLER Reply:
June 11th, 2011 at 10:11 pm
the only thing community banks need is the same marginal cost of funds at the larger banks.
right now their cost of funds is maybe 100 bp higher
And, as per my ‘proposals’ this is easily accomplished by keeping the discount rate at the fed funds target rate and opening it to all banks.
beowulf Reply:
June 11th, 2011 at 11:28 pm
@Winslow r.,
You’re right, community banks don’t do themselves any favors by allying themselves with big banks.
Art Reply:
June 12th, 2011 at 9:34 am
@Winslow R.,
http://www.smartmoney.com/invest/markets/how-to-start-your-own-bank/
Reply
Winslow R. Reply:
June 12th, 2011 at 2:13 pm
@Art,
When it takes me less than 30 minutes to understand why ‘well capitalized’ BCT Federal sinks like a rock, I might consider it :)
http://www.ibanknet.com/scripts/callreports/filist.aspx?type=failures
Reply
Matt Franko Reply:
June 12th, 2011 at 5:35 pm
@Winslow R.,
Wins,
It’s like you can have all the sophisticated risk modeling you can dream of, but when the govt sector is simply unwilling to support AD thru fiscal policy, all that risk modeling can then be looked at as a big waste of time.
In a related way, it looks like the credit ratings agencies are starting to look at willingness to pay when they are looking at sovereign debt, tho not quite there yet on being able to state 100% that ability to pay is not an issue.
Now maybe banking risk models should start to look at willingness of the govt sector to support AD thru fiscal. We know govt has the ability, but not the willingness to support AD. This is probably the biggest risk in US banking right now, and it probably is not accounted for in any risk models (other than Warren’s head;).
It would probably be good to be part of a small group to start a bank someday like the article that Art links to talks about, but without the willingness of the current govt to sustain AD (and actually just the opposite if you take them at their word!) I too think it is wise right now to hold off. Resp,
WARREN MOSLER Reply:
June 12th, 2011 at 10:39 pm
right, the main risk to banking is the risk the govt lets demand tank, like it did mid 2008.
Winslow R. Reply:
June 13th, 2011 at 2:31 am
Perhaps this block, pushing stagnation in AD, needs a face?
Who are these guys? Pimco? The Koch Brothers? Economists pushing for ‘a balanced world economy’ waiting for China to catch up like Japan did? Big bankers ready to snatch up small banks for pennies on the dollar as their profits are squeezed?
June 11th, 2011 at 10:56 pm
“the only thing community banks need is the same marginal cost of funds at the larger banks.
right now their cost of funds is maybe 100 bp higher”
Wouldn’t it be better politics to justify asking for more and then settle for the same?
Reply
WARREN MOSLER Reply:
June 12th, 2011 at 10:24 am
that’s a different story! but the lobbyists don’t even ask for cost of funds equalization
Reply
June 12th, 2011 at 11:45 am
(I think you meant: “so what happened is that hiking capital ratios from 1% to 100% …”)
Using your example:
Bank X – 1 per cent equity financed
Bank Y – 100 per cent equity financed
Same assets
Bank X and Bank Y have the same assets (a set of designated assets A). There is no reason that their assets should be priced differently, provided their capital structure is subject to market pricing. I.e. there’s no reason why their capital structure should cause their assets to be priced differently, provided their capital structure is subject to market pricing. Furthermore, even if the non-equity component of Bank X’s capital structure is insured by the government, there is no reason its assets should be priced differently provided that it is paying an insurance premium set by the market. That insurance premium can be determined by option pricing.
I can hold the basket of assets A in various ways: as a standalone portfolio, by purchasing the equity of Y, or by purchasing the combination of equity and non-equity in X. Pricing of A will be the same in all cases provided that all capital structure components are priced at market. This is ensured by (option) arbitrage pricing.
So in this base case equivalence model, the purpose of bank capital is to absorb first loss, and the capital allocation rule has no bearing on asset pricing.
Where it will have an effect is if government distorts the pricing of insured non-equity capital (deposit insurance for the most part), for example, by subsidizing it.
The worst case, which I noted above, is that where the government sets low capital requirements and doesn’t price out the cost of insurance at all. This is a gross distortion of market pricing, and will clearly cause assets to be mispriced – because equity holders have the benefit of a free put option.
The ideal case – particularly in the context of your proposal to broaden and simplify the insurance mechanism (e.g. full deposit insurance, unlimited fed funds) – is to set the strike price for the call option (the capital requirement) sufficiently high that the potential for mispricing of the “put” (the deposit insurance) is minimized. Because there’s less “tail risk” to be absorbed by the put option, correctly priced insurance is cheaper, and risk of mispricing it less consequential.
The regulatory regime has to deal with these issues – and I think it has to deal with them in your proposals as well. Somebody has to determine the strike price for the call option (the capital requirement). That strike determines the risk that is distributed to the equity holders and the residual risk remaining for the insurance put option. That structure in combination with the regulator’s decision on pricing the put option then determines whether any significant pricing distortion will be transmitted into the marketplace.
I actually think your proposal implicitly assumes very low tail risk for the put option. And that means higher rather than lower capital requirements. That means little pricing distortion and little effect on asset pricing due to any insurance mispricing, compared to the pricing of the same assets on a stand-alone basis.
Finally, I note again the difference between risk and capital, as well as the difference between nominal assets and risk weighted assets. “High” or “higher” capital requirements means higher capital allocated per quantum of risk weight. That can still happen even with a lower aggregate risk weighted banking system, as envisaged in your proposals.
To restate, bottom line, your proposal to down-size risk in the banking system, which certainly has its merits, is not necessarily inconsistent with up-sizing the capital requirements per quantum of risk.
All that said, the role of equity as first loss protection is a fact. We can debate asset pricing nuances around that, but it doesn’t change or replace that fact. I’d just position any asset pricing nuances a little differently, as above.
P.S. the issue of the difference between a 300 per cent ROE and a 3 per cent ROE in your example doesn’t automatically suggest any immediate conclusion relating to asset pricing adjustment. In an option arbitrage world, with the pricing of the respective capital structures determined at market (including insurance costs), these two results aren’t necessarily incompatible. They would be extremely incompatible if deposit insurance for the 1 per cent capital bank weren’t priced at market – but that’s a bit moot because the examples are meant to be extreme apart from that.
Reply
JKH Reply:
June 12th, 2011 at 12:08 pm
@JKH,
Re the last P.S., that 300 is the margin before insurance costs. ROE will be less with insurance costs. If insurance is mispriced, that will affect asset pricing as well, as per discussion.
Reply
WARREN MOSLER Reply:
June 12th, 2011 at 10:36 pm
I’ll try to get to all the banking questions here.
Yes, the price of fdic insurance is another variable I left out. It serves to raise interest rates charged by banks in general via increasing the bank’s cost of funds.
And yes, there is some fdic premium where a bank with a 1% capital requirement would make the same roe as a bank with a 100% capital requirement (and therefore no fdic insurance to pay).
What you are saying is that changing the price of risk via capital requirements can be offset with fdic premiums, to the point that banks would be indifferent to having 100% capital requirements, which is the point where it makes no sense to be a bank, for purposes of lending, as you can just as easily lend out your own capital without being a bank.
To which I agree.
And, again, I just think you are making my point? Remember, I agree regulators use capital as protection of taxpayer money. What I’m saying is that if they better understood banking dynamics, they’d use capital requirements for the pricing of risk.
Regarding fdic insurance, it all comes back to the public purpose of having govt involved in banking at all, in this case on the lending side.
The answer is public purpose is served only if there is public purpose in making loans based on credit analysis rather than market value, as the private sector can deal with loans based on market value just fine. But only with ‘stable’ liabilities can loans be made on credit analysis.
And yes, banks could presumably fund themselves without deposit insurance and only lend if they could borrow at matched maturities, but that would mean lending would be a function of banks being able to raise said liabilities. So, again, only if public purpose is served by removing those vagaries of the liability side is govt support appropriate.
So assuming we do find public purpose in lending on credit analysis, and we see public purpose in the govt establishing the cost of funds for banks (and not have that pricing subject to market vagaries) let’s look at fdic insurance.
FDIC insurance is a bank tax that’s entirely passed through to borrowers as a higher interest rate that’s a function of the fdic levies.
And, as above, if those charges are so high it makes banks noncompetitive to those simply lending their own unlevered funds,
the presumed public purpose served by banking isn’t happening, presumably to the detriment of the general welfare.
And, as you stated, that level of fdic insurance that makes banks marginally noncompetitive is, mathematically, the ‘right’ price for the risk involved.
So yes, FDIC insurance is a subsidy, all for public purpose, or, again, there’s no reason to let public/private banks lend in the first place.
And, in fact, to serve said public purpose, there should be no fdic premiums, to make sure bank’s borrowers, as targeted by regulations, get funded at minimum spreads to the fed’s targeted cost of funds for banks. and with no fdic premiums, lower capital ratios will lower what banks charge borrowers, not in a straight line and with complications, as previously discussed. And yes, because FDIC isn’t charging premiums that ‘close the identity’ with capital ratios and risk.
so to best serve public purpose, i’ve proposed
asset regulation to protect taxpayer dollars,
no fdic insurance premiums,
and capital ratios determined in the context of the pricing of risk, which is the only reason to have private capital in banking to begin with.
Reply
RSJ Reply:
June 13th, 2011 at 12:54 am
@WARREN MOSLER,
Market value also takes credit analysis into account. This is a false dichotomy.
The public purpose, on the lending side is that banks extend credit to those who do not have access to market funding, either because they cannot afford to issue GAAP compliant audited financial statements, or because the amount they wish to borrow is so small that the underwriting fees would make a bond offering prohibitive.
As this covers the majority of households and small businesses, there is a public purpose to extending access to the credit markets indirectly via banks.
But access to the credit markets is not the same as subsidized or penalized access. Access is access.
Banks can aggregate all the small loans, and perform their own accounting review. If the banks are privately held, then by proxy they are always “selling” the aggregated asset pool to the market, where those aggregated assets are priced at the market price.
The public purpose ends as soon as the household has been granted (indirect) access to the credit markets by receiving the loan. There is no public purpose served by driving the price of the loan higher or lower than what the price would be if the household had borrowed from the credit markets directly. Public *harm* is guaranteed to occur when there is a long run divergence between the two prices. Whenever an asset has two different prices, this creates economic rents.
Public purpose is best served when bank equity holders do not receive any more or less (risk-adjusted) return by purchasing bank equity than they would have received if they had lent to the household directly, and regulation of banks should be geared, first and foremost, to trying to ensure that this outcome occurs.
That means that unlike your proposal, banks need to pay deposit insurance, and their overall cost of funds cannot be allowed to be lower than the cost of funds of
non-financial businesses that do not borrow from banks.
Reply
WARREN MOSLER Reply:
June 13th, 2011 at 4:57 pm
responding to this and other banking posts.
Bank lending is about leveraged lending. If you’re just going to lend out your own capital- you own money- bank lending is moot. You can just do it without a bank. There’s no advantage for a lender in being a bank if the capital ratio is 100%.
Same with non bank lending. It’s about leverage as well. GE credit, for example, has about a 5:1 leverage ratio, where for every dollar it lends 20 cents is it’s own money and 80 cents is borrowed in the marketplace.
Yes, market value takes credit analysis into account. But what I meant by lending on market value is that non bank lenders, like GE, look to borrow 80 cents for each dollar they loan. And presumably they borrow at lower rates than the rates they charge for loans. And the amount the marketplace will lend them is a function of the perceived market value of the loans they make. And that market value is subject to change, which puts them at risk. In fact, in 2008 GE wound up selling its commercial paper to the govt. to stay afloat. Other, smaller private lenders didn’t get federal dollars like GE did and didn’t fare so well. Which is my point about that lending model. Those types of lenders are lending on market value in that they can only fund themselves based on market value. And the model carries the inherent risk of ‘roll over risk’ as even if short term loans are made to good credits, at maturity those credits might not be able to roll their funding and the lender gets stuck with extending that loan to that credit, etc.
Banks, on the other hand, can lend on credit analysis and not worry about market value, as they fund themselves with FDIC insured deposits, and therefore depositors don’t care what the bank’s doing with their deposits. Then it’s up to the FDIC makes sure banks are in compliance with their lending requirements, etc.
If you don’t see any public purpose to a bank being able to make those types of loans, fine, and make sure you let your representatives know at the ballot box…
Agreed on the too small for public market funding point. But there have always been non banks making small loans.
In the old days there was Household Finance and Beneficial Finance, for example, and we have lots of pay day lending by non banks today. In the 1970′s when I covered car dealers for the savings bank i worked for, the dealers called them the blood banks, as in ‘…send him to bloodbank for the downstroke…)
Yes, banks could resell loans to the marketplace, but why? what’s the public purpose?
Are you saying there is economic rent possible on the part of the equity holder?
Yes, I agree that could happen. Depends on how much competition the regulators allow for banking. Most recently seems to me competition in banking had driven down returns on equity from lending? So if banks lend at rates lower than borrower could otherwise attain, who’s getting the economic rent? The sellers of the cars and toasters and houses being financed? Seems competition keeps those sellers margins in line as well?
Back to no charge for deposit insurance? And since most banks fail because they did things they weren’t supposed to do, deposit insurance penalizes the banks that kept between the lines to pay for the cheaters.
RSJ Reply:
June 13th, 2011 at 11:15 pm
Exactly. When you are leveraged, you receive a greater income stream for your investment, but at the expense of more risk. The added risk — the possibility of default — is the price you pay for the greater cash-flow. It must be this way.
Now what you are proposing is a greater return without risk — you believe banks have a natural right to alpha, just because they are banks.
Now we agree that market fluctuations can be disruptive, so it might be better to replace market valuation with administrative valuation. But the mark-to-model values must always be smoothed versions of the market prices, and more importantly, as they are smoothed versions, additional taxes or fees need to be paid by banks as their risk is being reduced but their returns are not being reduced.
The entire system should result in no greater risk-adjusted earnings as a result of leveraged lending than as a result of fully equity-financed lending. No one should be able to obtain alpha, and certainly no class of institutions should get alpha because of their capital structure.
WARREN MOSLER Reply:
June 14th, 2011 at 7:59 am
but if all the banks have ‘a greater return without risk’ to use your phrase, and compete with each other, the rates they charge fall as do the returns on equity.
June 12th, 2011 at 12:53 pm
Warren -
From “Proposals for the banking system…..”:
“So the only way the Fed can fully stabilize the fed funds rate at its target rate is to ***simple*** offer to provide unlimited funds at that rate as well as offer to accept fed funds deposits at that same target rate.”
Next time you get around to an edit, “simple” should be “simply”.
Good stuff! Thanks!
Reply
June 12th, 2011 at 12:59 pm
For example, with a 10% capital ratio banks have 10% private capital, and 90% tax payer money (via FDIC deposit insurance).
That is, assuming a 100% deposit insurance right?
If we look at things your way, shouldn’t a bank with a 10% capital ratio be taxed at 90% on its profits and a bank with 50% capital ratio be taxed 50%? In that case it would be enough to set any minimum capital ratio required for a bank could operate but the bank is free to determine its capital structure.
Higher capital requirements lower returns on investment, but risk goes down as well.
Do you mean risk of bankruptcy?
Reply
beowulf Reply:
June 12th, 2011 at 5:36 pm
@MamMoTh,
Actually the FDIC recently changed its deposit insurance fees in a way that I’m not sure eventhe Fed has completely wrapped their brains around yet. To copy what I just wrote to RSJ about this… The new rules mandated by Dodd-Frank on Apr 1 changing the “tax base” for their deposit insurance fees from bank deposits to bank assets adjusted for risk. As with the RSJ “tax bank rents” plan, it also adjusts for long term unsecured debts.
http://www.corporatefinancialweeklydigest.com/2011/02/articles/banking/fdic-approves-final-rule-of-assessments-dividends-assessment-base-and-large-bank-pricing/
So the Fed giveth interest on reserves and the FDIC taketh away.
The FDIC’s actions would have the same effect as a cut in the interest rate the Federal Reserve pays banks on excess reserves,” said Joseph Abate, money-market strategist at Barclays in New York.
http://www.businessweek.com/news/2011-01-08/near-zero-short-term-interest-rates-may-go-lower-under-fdic-rule.html
When QE2 was announced, there were a number of estimates of impact. Ours and others centered on about 2 to 3 basis points for each $100 billion. QE2 is about $600 billion in size. At 2.5 basis points per each $100 bn, the total value of QE2 is about 15 basis points reduction in interest rates, contrasted with where the rates might otherwise be. The new FDIC fee action on April 1 creates a “wedge” by imposing a cost on the entire banking system. We estimate (as does Barclays) that the wedge is about 15 basis points. Thus, FDIC fees will offset QE2 in full.
http://www.ritholtz.com/blog/2011/04/fdic-fed-more-questions-than-answers/
Reply
WARREN MOSLER Reply:
June 12th, 2011 at 10:38 pm
right, assuming 100% deposit insurance.
what would the public purpose of your proposal be?
yes, risk of loss
Reply
June 13th, 2011 at 7:54 am
@WARREN MOSLER,
“What you are saying is that changing the price of risk via capital requirements can be offset with fdic premiums, to the point that banks would be indifferent to having 100% capital requirements, which is the point where it makes no sense to be a bank, for purposes of lending, as you can just as easily lend out your own capital without being a bank.”
Indifference doesn’t mean one alternative suddenly becomes preferable to the other. It means either alternative could deliver superior returns through the competitive process.
“Remember, I agree regulators use capital as protection of taxpayer money. What I’m saying is that if they better understood banking dynamics, they’d use capital requirements for the pricing of risk.”
But the first thing you said was:
“The real problem is if you understand what a bank is, you wouldn’t be trying to use capital ratios to protect taxpayer money.”
Again, it’s simply a fact that equity is first loss protection. Somebody has to set the level of first loss protection. Somebody has to decide on a ratio.
You may in addition want to tinker with the effect of regulation on market pricing by subsidizing the economic cost of deposit insurance. But that’s supplementary to setting capital ratios, which must be done to establish the loss protection level.
So if you combine the two somehow, I might have an easier time with it, as opposed to rejecting the quantum effect for the price effect.
But the price effect needs more elaboration in any event. If there is a subsidization of the economic cost of deposit insurance, that becomes a benefit to the non government sector. That benefit may be distributed across borrowers, depositors and investors – by affecting lending rates, deposit rates, and return on equity. There’s no reason to assume that it will translate entirely to asset pricing. It will be dissipated.
“The answer is public purpose is served only if there is public purpose in making loans based on credit analysis rather than market value”
Everything’s connected, but this issue is one level down. It’s a risk issue, but it’s only one aspect of the full spectrum of asset risk issues. It’s a specific improvement you are proposing for risk management, which is fine.
“So, again, only if public purpose is served by removing those vagaries of the liability side is govt support appropriate.”
Maybe – your proposals certainly streamline and simplify the profile of banking risk. But risk remains both on the asset side and the equity side.
“FDIC insurance is a bank tax that’s entirely passed through to borrowers as a higher interest rate that’s a function of the fdic levies.”
Let’s clarify. It’s not the insurance that is the cost. It’s the insurance premium.
Furthermore, the provision of the insurance benefit and the charging of a market premium for it is net neutral – it is not a net tax to banking.
It is the subsidization of that premium that is a transfer or a net “tax expenditure” to banking.
And that transfer is not necessarily passed through only to borrowers. As noted, it can be transferred as a package distributed to all stakeholders – borrower, depositors, and investors.
Such a net transfer will distort market pricing – in bank asset markets, deposit markets, and equity markets.
“if those charges are so high it makes banks noncompetitive to those simply lending their own unlevered funds, the presumed public purpose served by banking isn’t happening, presumably to the detriment of the general welfare.”
So it boils down to you being in favour of net subsidies to banking (all stakeholders) through off-market deposit insurance pricing. That means you are exposing the taxpayer to tail risk. What I’ve said earlier is that the more you do this, the more important the level of first loss protection becomes – the capital ratio that the regulator must set. That minimizes the tail risk to be subsidized. This is where you say I’m making your point for you. But I’m not making your point. I’m saying that your point must be conditioned on the prior fact that the government should set the amount of risk exposure whose cost is being subsidized – by setting the strike price of the call option (the capital level). You have rejected this qualification, which is why I’m not making your point for you.
Reply
WARREN MOSLER Reply:
June 13th, 2011 at 5:10 pm
“The real problem is if you understand what a bank is, you wouldn’t be trying to use capital ratios to protect taxpayer money.”
Again, it’s simply a fact that equity is first loss protection. Somebody has to set the level of first loss protection. Somebody has to decide on a ratio.
How about this: Using capital ratios as a tool for first loss protection is like taking your screw driver out of your tool box (instead of your hammer) to hammer a nail.
Yes, you could do it, and it sort of works, but if you understood your tools you wouldn’t do it.
And yes, someone has to decide on the capital ratio, but my point is that decision should be based on what that ratio does to the pricing of risk. And the pricing of risk is the reason to have public/private banking rather than just public banking with no private capital.
I think the rest is addressed in the response i just posted?
Reply
JKH Reply:
June 13th, 2011 at 6:17 pm
@WARREN MOSLER,
nope; difference of views here at the most fundamental level, which is interesting
much appreciate your responses though; thanks
Reply
WARREN MOSLER Reply:
June 13th, 2011 at 6:27 pm
ok, same, good discussion,
and one where there’s plenty of room for discussion on what best serves public purpose.
which gets back to the larger point, there is no discussion of this type going on at the policy making level
that I’ve ever heard.
Worse, mostly you hear arguments like ‘that didn’t have anything to do with the cause or depth of the financial crisis, so why tamper with it?’
June 14th, 2011 at 12:50 am
Sorry whats the debate ?
Methinks raising capital adequacy ratio will raise lending rates but it doesn’t last long and once banks reach higher capital adequacy, rates will come back to a lower level.
Reply
WARREN MOSLER Reply:
June 14th, 2011 at 8:02 am
right in that they compete themselves down to market clearing returns on equity.
Reply