Banking on Capital Requirements

The search for blame on the banking crisis which carved out our Great Crater has now passed on to the next phase: what to do next? Thank goodness for that, but so far I haven't seen much in the way of good ideas.

One suggestion, made this week in The Nation, is very simplistic: Break Up the Big Banks! If they're "Too Big To Fail," making them smaller will fix the problem. I doubt that antitrust law as constituted will support this approach, and the trend has been the opposite: permitting--rather, facilitating--big acquisitions of troubled large institutions by the superbanks. And, while all the America's largest banks received bailouts during the peak of the crisis, not all of them remain basket cases (I'd point particularly to J.P. Morgan Chase and Wells Fargo as having strong recovery prospects, ignoring Goldman Sachs and American Express as not really being banks, though they took advantage of the bailout offer to become officially "bank holding companies"). Further, not all the large banks abroad have had deep problems, particularly the likes of Standard Chartered, HSBC, and BNP. It's not size, it's what they do (or don't).

Mark-to-market accounting is another false bogey: some of the banks have gotten behind a proposal to change accounting practices again (an emergency change was made earlier this year to allow some of the toxic assets to be kept on the books at estimated value, rather than market value, when there was no market). A new proposal would give banks the ability to review their own accounting standards, by putting them on a review council on FASB, and taking that power from the SEC. An interesting discussion of this brings out the point that this proposal has the support of the community banks, which are viewed as innocent of causing the recent debacle and which have a very receptive ear from Congress.

Capital Ideas


I'm not in favor of putting these particular lunatics in charge of their accounting asylum. As far as mark-to-market, some emergency change may have been necessary in the peak of the crisis early this year (the toxic assets were not worthless, though no one cared to bid on them), but I remain incredulous toward the notion that these could not or cannot be valued, and I am strongly in favor of regulation both of all mortgage-backed-security offerings and of who may purchase them and for what purposes.

I do have some sympathy for the banks in a predicament they are currently experiencing, though. Rising credit losses such as virtually all banks are experiencing will cause both a decrease in capital available to backstop creating new loans and an increase in the amount of capital required to be dedicated to reserves against future losses for the loans on their books. Additional pressure on banks' capital comes for those who have Federal government assets from the bailout. The result is a continuation of scarce credit conditions on Main Street and political pressure on the banks to make loans that their rules of governance will not, and should not, permit.

One idea to address this double-bind is for the government to come to the aid of community banks with assistance--perhaps for a limited time--to reduce the risk of new loans to small businesses and non-profit organizations. Taking on a share of the potential losses for loans that are destined to produce new hires, or even to reduce job losses, would make such loans more attractive to banks, reduce the capital required for them, and thus bring a boost to employment.

A more fundamental systemic revision would address the nature of banks' loan-loss reserves. These are supposed to be forward-looking, in the sense of preventing direct capital charges to banks in the future when loans go bad. This works to some extent with very large individual loans, but for ordinary mortgages and consumer loans it has the effect of magnifying the effect of cyclical economic downturns and freezing up credit.

A sensible revision would encourage banks to take extra reserves earlier in the credit cycle, in order that the remaining loans would be fully reserved against a continuing downturn and that the banks would show improving reserve costs, allowing them to resume lending, sooner in a recovery. This would actually help banks' profitability through the cycle: the problem is that they would need to act more forcefully to recognize losses sooner. The means of encouragement could be several, ranging from regulatory guidance to some requirement to incentives.

Update, Nov. 19:

I neglected in my initial posting to include another idea I have had: the way to deal with the TBTF is to give them incentives to break apart on their own through capital requirements. Very simply, a bank that has both consumer loans and deposits and also speculates on buying mortgage-backed securities and extensive hedging in derivatives should be required to carry a higher percentage of capital (to protect the public's interest, not just the stockholders') than would two banks of the same combined size, divided up into a traditional bank and an investment bank. Given those incentives, to name names, Citibank, Bank of America, and J.P. Morgan Chase would likely make the smart move to protect their margins and divide up without being coerced into doing so.

I am happy to say that it appears that the draft financial reform legislation being introduced by Sen. Chris Dodd is including this concept.