By Gregory Turnbull-Schwartz
Senators Brown and Vitter want the US to abandon the Basel process and impose capital requirements of 15% for the largest US banks and 8% for the rest. They say such a requirement would not impact lending nor the economy.
What is the right level of capital for a bank? Should capital requirements be related to which sorts of risks banks take? Are the senators correct in asserting that higher capital requirements will not halt the provision of credit to the economy? We like the idea of higher capital and more simple measures. But the senators are misguided or misleading about the potential impact on the economy and have overvalued simplicity at the expense of common sense.
The question ‘what is the right level of equity in a bank’ is difficult to answer and any answer carries at least a taint of being arbitrary. If 15% seems ok, why not 15.5% or 14%? A figure of 20% of tangible equity to total assets was recently cited by Robert Jenkins, member of the Financial Policy Committee of the Bank of England. Many emerging markets banks carry double digit tangible equity capital of total assets (though few as high as 15%) and have performed quite nicely for shareholders, so they are not in the realm of insanity. But to suggest there would not be consequences is taking it too far.
If implemented, Citigroup shares, for example could devalue dramatically. No shareholder would sit around waiting to have their ownership diluted by the massive issuance required to reach the 15% target. Current tangible common equity stands at about $155bn. To reach the target, it would need an additional $119bn, roughly the market capitalization of Disney. A bank with declining interest margins, a shrinking loan book and a hostile and uncertain regulatory environment walks into a bar, and asks for an extra 75% of equity investment… A realistic proposition, or the start of a bad joke?
Should the level of equity required be set by size or riskiness of activity? If the senators get their way, a bank with 100% of its loans made to commercial real estate lending in a single city would have the same requirement as a bank making owner-occupied mortgage loans on low loan-to-value and loan-to-income ratios spread across three metropolitan areas. Given the loan margins of the first bank will be considerably higher than the second, guess which bank will attract equity investment? And so the riskier bank grows, while the conservative one stagnates. That cannot be a sensible basis for systemic stability. The proposed measure is simple, but it is not a sufficient measure for comparing complex businesses.
There is no doubt that requiring Citigroup to increase its tangible common equity as a portion of its assets would cause it to reduce assets and harm the economic recovery. It simply could not raise $119bn of equity. And that equity hole might not reduce much as the bank shrank because shareholders would actively sell, rather than hang around to receive their shares of a shrinking pie. Equity requires compensation and the bank cannot really satisfy existing equity holders as evidenced by the price/book value being in the 0.75 region, showing investors would not currently pay even the current book value of the bank. Failing to attract equity investment, Citi would have to reduce assets to satisfy the senators’ criteria. Citigroup and other large US banks shrinking would cause significant credit contraction in the US economy.
The Brown and Vitters Bill caters to a wish for simplicity, and to the fear of ordinary taxpayers that they may once again be called upon to bail out a bank. But the senators have not acknowledged the economic impact of their proposal. The quest for simplicity and better capitalisation levels are laudable but it is a shame that energy and time is being diverted from improving the Basel framework and existing US legislation.
Gregory Turnbull-Schwartz is a fixed income manager at Kames Capital
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