Christian Chavagneux: You identify “leverage” as the key challenge of banking reform. Why?
Robert Jenkins : We are working our way through the largest credit bubble in history. Now bubbles are not new. They are always the same and always a little bit different. They all feature heavy doses of greed, stupidity and leverage. What made the recent bubble different is the extraordinary degree of leverage. We can not abolish greed and we will not outlaw stupidity. But we can and must reduce excessive leverage. Current reforms fail to do so.
But is it not true that the new regulatory regime (Basel III) raises capital requirements and limits leverage?
There are two aspects of the Basel III accords which deal with leverage. The first is to raise the amount of loss absorbing capital required as a percentage of a bank’s risk weighted assets (RWA). The second is the imposition of an overall leverage ratio.
As to the first, the question is not whether capital requirements are being raised but rather are they being raised sufficient to make a difference to financial stability. I let you be the judge. Let’s take an example. “CDOs Squared” were perhaps the most notorious fruit of faulty financial engineering by the banking industry. This is a security, backed by a security, backed by a pool of residential loans to US subprime borrowers. Most of these securities were rated AAA by the world’s leading credit rating agencies. They quickly plunged in value by double digit percentages during the downturn. So how much loss absorbing capital do the new “tougher” rules require to support every 100 euros of AAA rated CDOs squared? Answer: 1 euro and 35 cents. That is less than 1.4% to protect against losses from a security that neither bankers, investors, regulators nor credit agencies were able to properly price. Are you reassured?
But there is also a new leverage ratio – a backstop just in case regulators get it wrong on Risk Weighted Capital requirements.
Very true. The Basel III rules require an overall minimum of loss absorbing equity equal to 3% of a bank’s total assets. Put another way, banks will be able to fund 97% of their risk taking with debt (borrowings) and only 3% with shareholder equity. That means that a mere 3% decline in the value of a bank’s risk assets wipes out 100% of shareholder equity. This is another way of saying that the bank is leveraged 33 times. Such is the level of the “cap” on leverage for the future. Good luck. By the way, the average hedge fund is leveraged two and one half times by comparison. So the new rules allow our biggest banks to trade at levels of leverage more than 13 times that of the the average hedge fund.
Yes, but after exhausting its cushion of equity, the new rules will also force a bail-in by bondholders, not the taxpayer.
Right. So how do you suppose that’s going to work out? For every one euro of shareholder supplied, loss absorbing equity, a bank can acquire 33 euros of risky assets. He does this by using one euro of equity funding and by borrowing 32 euros from depositors and bond investors. The bond holder (the bank’s creditor) now knows that once the slim sliver of equity is eroded, the government will come after him and force him to convert his bond into the shares of a troubled bank. How long do you suppose that investor is going to stick around with his bonds as market rumours swirl? How long will other creditors to the bank wait to see if the bank actually has enough equity to avoid bail in? How long would you wait? The more credible the threat of “bail in” the faster bond holders will bail out and bank funding will dry up. No funding, no lending. Absent taxpayer funded support – no bank.
In summary, capital levels will be somewhat higher and leverage levels somewhat lower. But they will not be sufficiently different to achieve a stable system free from taxpayer subsidies and bailouts. It’s a bit like speed limits. If you announce that you have reduced the speed limit in urban areas by 25% it will sound like a tough crackdown on reckless driving. But if the result merely lowers the limit from 200 to 150 kph then it will hardly help.
Sounds convincing. So why haven’t the authorities adopted stricter standards?
The bank lobby has been successful at fighting reform generally and capital requirements in particular.
Money in the US. Intellectual capture in the west more generally.
What do you mean by intellectual capture?
Bankers have succeeded in persuading pundits, public and politicians that higher capital is bad for the economy, bad for shareholder value and bad for the competitiveness of one’s national financial champions. They want you to believe that society has to choose between safety and growth; between safety and shareholder value; and between a safe financial system and one that is competitive. These represent false choices and pernicious myths.
Can you explain?
The first myth is that we must choose between safety and growth. The banking lobby would have you believe that higher capital requirements and lower leverage will damage economic growth and retard the recovery. “Increase our capital requirements and we will reduce our lending!” You have heard it before. I can hear now. But take a minute to do the math. Bank “A” has a trillion euro balance sheet supported by 50 billion of equity. Now, let’s double the equity required to 100 billion and retire 50 billion of bank debt. Has the balance sheet shrunk? No. Has the bank had to cut credit? No. Does more capital necessarily lead to less lending? No. So does society have to choose between safety and growth? No. So much for myth number one. But if you fall for this fallacy you will agonize between doing what is right for the economy short term and what is right for stability and your country long term. Bankers have exploited this fear. Depending on their political weight, the degree of banking recapitalization required, and the prospects for domestic growth, different nations will automatically have different views as to the appropriate levels of capital and the timing with which to reach them. Agreement comes at the lowest common denominator and that has been very low indeed.
And the second myth?
To the exposure of myth number one, bankers retort: “How dumb can you be?” “Equity is expensive. Make us double our equity and you will lower our Return on Equity, damage shareholder value and discourage the supply of bank capital.” So here we have myth number two. Let me take it in two parts.
First, short term RoE is a poor proxy for medium term profitability much less shareholder value. Just ask yourself: has this fixation on double digit RoE achieved it over time? No. Did the annual emphasis on RoE produce attractive and sustainable shareholder returns? No. So, does a short-term focus on RoE equate to medium term profitability and long term shareholder value? No. Why? Because it does not adjust for risk. The returns (and related bonuses) may come short term, but the risks come later. (Later came recently.)
Second, the prospective investor is no longer interested in promises of short term RoE; he is interested in achieving attractive risk-adjusted returns. The higher the perceived risk, the higher the return required; the lower the perceived risk, the lower the return expected. Capital will flow in either combination but its price will be different. Banks with little equity and lots of leverage are more risky than those with less leverage and more equity. Investors in both bank equity and bank debt will charge accordingly. That “charge” is the bank’s cost of capital. And given that markets reward more predictable earnings with higher multiples, even lower earnings need not lower the market cap, dividends or shareholder returns. Not convinced? Look at bank share prices. The market is attaching relatively higher valuations to the relatively less leveraged.
And myth number three?
Indeed. The third myth follows from the second – to wit: governments must choose between domestic financial stability and the competitiveness of their domestic financial centers. Clearly, if you believe that higher capital requirements damage bank profitability and shareholder returns then you must also fear for the competitiveness of your domestic banking champions, the attractiveness of your country as a global Finanzplatz and the tax take for your treasury. But as we have seen, one need not choose between safer banks and profitable banking. PwC underscores this point in its 2012 report entitled “Banking Industry Reform: a New Equilibrium.” Less leverage will not only be rewarded with a lower cost of capital but also in lower costs for most sources of funding – from bank debt to wholesale deposits. And in terms of market share, the strongest banks are growing their clientele (eg revenue) at the expense of weaker competitors. In a world of increased risk awareness, letting your banks off the capital hook will likely damage not enhance their long term ability to compete. Extend the analogy to your country as financial centre: where would clients and counterparties like best to do business? In a stable, well regulated regime? Or in one burying problems and ducking issues because regulators fear their banking system too fragile to fix? Needless to say, the tried and booed alternative – light touch/highly leveraged regimes proved devastating to gross domestic product, the taxman’s take and to public confidence in banking and its regulation.
But if these are in fact myths, why do bankers propagate them?
Why indeed? Are they not working for their shareholders? Do they not have a paramount interest in financial stability? Do they not want their respective financial centres to be strong and confidence inspiring? Surely they would never dream of putting their personal interests ahead of those of society and their owners? I will let you decide. But I can think of a few possible explanations. First, it is conceivable that many bankers simply do not understand the basics. It is shocking but I have not met a single senior banker who understands his cost of capital. Perhaps I should get out more. Second, many do not understand fully the notion of risk-adjusted returns – witness their recent quest gone wrong of chasing returns without adequate understanding of risk. Third, many managements remain transfixed by the notion of RoE as the primary measure of profitability. They have promised it to their boards and to their shareholders. The targets were written into their remuneration plans. Results fed their bonuses. And there is no doubt about it, all else being equal, higher equity reduces the measure of short term RoE. Never mind that it is the wrong measure and therefore the wrong target. Finally, it is possible that some bankers and boards actually wish they had more capital – but dare not admit it without putting their jobs at risk. This is partly because many have insisted throughout that they were “well capitalized” and partly because they demonstrably failed to tap the market for equity each time it could have been had more cheaply. But where forced by the authorities to raise equity, the stock has often risen significantly after the fact.
In summary, governments and their regulators have been operating on the basis of a series of myths and false choices. This has produced suboptimum reform and complicated international coordination. In reality, one need not choose between better capitalized banks and economic growth. One need not choose between safer banks and profitable banking. And one need not choose between a stronger banking system and one that can compete – on the contrary. But as long as such fallacies frame the regulatory debate, decision makers will think in terms of trade-offs both domestic and international. Trade-offs in turn imply winners and losers. And given the primacy of national interest and continued influence of the banking lobby, international cooperation will suffer – producing agreements at the level of the lowest common denominator and woefully insufficient to resolve the greatest regulatory challenge of our time. Remove the myths and better regulation and coordination will follow. It’s not too late. Which is why the banking lobby remains in high gear. ■
This interview was conducted in late 2013 in English with Christian Chavagneux, founder and Editor of Alternatives Economiques and Member of Finance Watch. It was published in French in August 2014 in L’Economie politique n° 063 – juillet 2014 (pdf version).