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Wednesday, June 22, 2011

This is a wonderful idea! We don't want no stink'in Svengalis.

Bank capital, and the lack thereof, is one of the reasons we are where we are. Bank capital is what is left over after liabilities on a bank's balance sheet are subtracted from assets. The rest of the world calls it net worth but bankers have their own pet terms I suppose. Banks need capital to be able to absorb losses on their balance sheet from buying bad assets, like making loans to poor investors or buying mortgage-backed securities. When the bank's assets are worth less than their liabilities, then they have negative bank capital and are indeed bankrupt. Sounding familiar yet? Bank capital is also related to the leverage ratio of a bank. This ratio indicates how much bank capital, a.k.a. owner's equity, a.k.a. "skin in the game" a bank has to put up for, say, every $100 it borrows to buy assets. So, for example, a 2-to-1 leverage ratio would mean a bank must put $50 equity for every $100 it borrows. If it puts up $50 billion in equity to have assets of $100 billion and makes $5 billion in after-tax profit then it has a return on equity of 10%. Now, Presto-Changeo! What if a bank had a leverage ratio of 57-to-1? That means it could borrow $114 billion dollars for every $2 billion of its own skin in the game. If it made $5 billion in after-tax profit it would have a 250% return on equity. Ahhh, now we are talking baby! But could only absorb $2 billion + $1 in loan and asset losses before it went bankrupt, kaput and insolvent. And here you see the danger. Low equity and high leverage raise the return on equity but make the financial institution vulnerable to even the slightest downturns in asset values. High equity and low leverage lower the return on equity but provide safety against insolvency because banks have the capital to absorb losses. And remember, capital cannot be had nor can you re-capitalize by borrowing.

Well, Citibank was leveraged at 57-to-1 when it all went so terribly wrong. Madness in my book. When the losses started to pile up who did Citibank call for a capital infusion? Underdog? Super Chicken? No, they called the Arabs in Dubai. The Arabs cut a check for $7 billion in exchange for equity positions in Citibank. Bad bet. Citibank failed and got bailed out for the third time by the US government. But equity holders got nothing. And please remember that when US banks purchased Fannie and Freddie MBS they only had to put up $1.67 skin in the game for every $100 they borrowed to buy these securities. Still wondering why our banking system went KABOOM?

The way our financial system is now structured with the 2300 page Dodd-Frank bill, banks are heavily regulated with 2300 pages of what they can't do but yet the law still allows larger leverage ratios and lower equity. The implication is we will bailout again when your bets go bad and your capital is inadequate. What if we turned this on its head somewhat and said...go to it. Invest freely, well mostly, BUT we are going to make sure you have the adequate capital to absorb the losses and remain solvent. Note the implication is that leverage ratios would be on a short leash. And I think this is a great idea. Asset bubbles and leverage are our economic Svengalis. Get rid of whacko levels of leverage and you can stop most asset bubbles. The internet bubble still happened without leverage, and bubbles will still come around. But banks are forbidden from holding stocks and the internet craze was not fed with leverage, see? The result of that bubble popping was a very mild recession and a bunch of IT dweebs and tools looking for work. It did not bring the world's financial markets to the brink.

Read more about these bright ideas here.


bankster said...

As someone employed by a financial institution, I can tell you that bank capital isn't the same as owner's equity (assets minus liabilities). Owner's equity is included in Tier 1 capital, along with other attributes from the financial institution's financial statements - but they aren't the same.

Having said that, your analysis is pretty spot-on. Hurried legislation NEVER gets the job done, unless the job is to win votes via appealing to the emotions of a largely ignorant constituent base during times of weakness through enacting rushed legislation.

Randall Parker said...

Thanks so much Bankster. If you have a moment could you help me and the readers learn further what counts as bank capital?

Thanks so much,
R. Parker

bankster said...

Total bank capital is the sum of Tier 1 & Tier2 capital.

Tier 1 Capital includes permanent shareholder equity and disclosed reserves (including retained earnings) less goodwill

Tier 2 Capital includes general provisions, revaluation reserves, subordinated term debt and undisclosed reserves (not allowed for U.S. banks) hybrid (debt/equity) capital instruments, minus investments in unconsolidated financial subsidiaries and investments in other financial institution's capital