The Inadequacy of Capital Adequacy Regulations and a Public Equity Alternative

By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

Edward Kane argues, in a recent VOXEU communique (Jan. 30^th) that in the current information and ethical environments, regulating accounting leverage cannot adequately protect taxpayers from regulation-induced innovation.  A financial institution’s capital is defined as the difference between the value of its asset and liability positions. The idea that capital requirements can serve as a stabilization tool is based on the presumption that the strength of an institution’s hold on economic solvency can be proxied by the size of its capital position.

This way of crunching the numbers seems simple and reliable, but it is neither.  Accounting principles offer variations on how to decide which positions/cash flows are recorded, booked, and valued.  It provides the wrong incentives for survivability, management and government guarantees.

Capital adequacy is a flawed center piece for regulation as taught from the crisis.  Capital-requirements medicine not only failed to prevent the last crisis, it helped to inflate the shadow-banking and securitization bubbles.  The increasing the dosage and complexity of the capital-requirements medicine will not increase system stability.  Capital requirements have turned out to be toothless whenever tested.

The real problem is that the existence of government safety nets gives protected firms an incentive to shift risk to taxpayers.  Asking firms to hold more capital than they want lowers the return on equity than their current portfolio can achieve.  This means that installing tougher capital requirements has the predictable side effect of simultaneously increasing a firm’s appetite for risk, so as to increase the rate of return.

Meaningful reform must begin by changing the informational and ethical environment to make it harder for aggressive firms to extract uncompensated benefits from taxpayer-funded safety nets.  The value of taxpayers’ credit support deserves to be recorded as a contra-liability because it supplies implicit ‘safety-net capital’ that substitutes one-for-one for on-balance-sheet capital by transferring responsibility for financing.  Unlike a voluntary guarantee or put contract, taxpayers’ contingent equity position in difficult-to-fail firms is coerced, poorly disclosed and contractually unlimited, and cannot be traded away.  The value of safety-net capital can be extracted synthetically from the behavior of a firm’s stock price and return volatility since it contributes to a firm’s stock-market capitalization.

Conceiving of systemic risk as a portfolio of ‘taxpayer puts’ likens it to a disease that has two symptoms. Official definitions have focused almost exclusively on the primary symptom.  The extent to which authorities and industry sense a potential for, first, substantial ‘spillovers’ of defaults across a national or global network of leveraged financial counterparties and, second, from this hypothetical cascade of defaults to the real economy.  This first symptom combines exposure to common risk factors (e.g. poorly underwritten loans) with a jumble of debts that institutions owe to one another.  However, it neglects an important second symptom:  Inserting taxpayer interests into the financial-regulation game – the ability of ‘difficult-to-fail’ institutions to command bailout support from their own or other governments.

The value of any firm’s taxpayer put comes from a combination of its risk-taking and authorities’ selective exercise as an ‘option to rescue’ it in stressful circumstances. Large banking organizations endeavor to convert authorities' side of their firm's rescue option into something approaching a ‘conditioned reflex’. They do this by undertaking structural and portfolio adjustments designed to make their firm harder and scarier for authorities to fail and unwind.  Observationally, this corresponds to flows of accounting profits from building political clout and increasing their firm's size, complexity, leverage, connectedness, and/or maturity mismatch.  It is a contingent claim whose short side deserves to be serviced at market rates.  Drawing on the deposit-insurance literature, firms and officials can estimate the annual ‘Insurance Premium Percentage’ that a protected firm ought to pay on each dollar or euro of its debts.

The inevitability of industry leads and regulatory and legislative lags make it foolish to subject all very large banks to a fixed structure of premiums and risk weights over time.  For market and regulatory pressure to discipline and to potentially neutralize incentives for difficult-to-fail firms to ramp up the value of their taxpayer put, two conditions must be met: stockholder-contributed capital must increase with increases in the ex-ante volatility of their rate of return on assets; and the value of a firm’s taxpayer put must not rise with increases in the volatility of this return.  Logically, each requirement is in itself only a necessary condition.  The first is the minimal goal of the Basel system, and it usually holds.  But the second condition – which is needed to bring about sufficiency – is seldom met.

Cross-country differences in the costs of loophole mining help to explain why the current crisis proved more severe in financial centers and other high-income countries.  Basel's risk-weighted capital ratios failed to predict bank health or to signal the extent of zombie-bank gambling for resurrection.  During the crisis, the sudden surge in nonperforming loans simultaneously increased market discipline and panicked regulators.  This experience should have driven home the conceptual poverty of Basel’s attempts to risk-weight broad categories of assets.

Authorities need to put aside their unreliable, capital proxy.  They should measure, control, and price the ebb and flow of safety net benefits directly.  This requires: changes in corporate law aimed at establishing an equitable interest for taxpayers; and tasking regulators with seeing that taxpayers’ position in these firms is adequately serviced.  To carry out their side of this task, regulatory officials must redesign their information systems to focus specifically on tracking the changing value of their portfolio of taxpayer puts.

Large financial firms should be obliged to build information systems that bring to the surface the value of the taxpayer puts they enjoy.  Auditors and government monitors should be charged with double-checking the values reported.  Regulatory lags could be reduced if data on earnings and net worth were reported more frequently and responsible personnel were exposed to meaningful civil and criminal penalties for deliberately misleading regulators.

www.voxeu.org/article/inadequacy-capital-adequacy-regulations-and-public-equity-alternative

Monetary alchemy, fiscal science

By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

2013 marks the 100th anniversary of the US federal income tax and the establishment of the Federal Reserve. Jeffrey Frankel asks, in a recent VOXEU communique (Jan. 29^th), what lessons have we learnt about macroeconomic policy since then? This note assesses the postwar lessons and argues that fiscal expansion is much more likely to be effective in the short term than any monetary expansion stimulus. Indeed, compared with fiscal policy, monetary policy seems more alchemy than science.

It took time before the two new institutions became associated with the explicit concepts of fiscal policy and monetary policy respectively. It wasn’t until after the experience of the 1930s that they came to be viewed as potential instruments for managing the macroeconomy. John Maynard Keynes, of course, pointed out the advantages of expansionary fiscal policy in circumstances like the Great Depression. Milton Friedman blamed the Depression on the Fed for reducing money supply.

In subsequent debates: Keynes was associated with support for activist or discretionary policy. The aim was a countercyclical response to economic fluctuations; and Friedman opposed activist or discretionary policy, believing that government institutions – were unable to time their interventions effectively.

After the second world war, the lessons of the 1930s were incorporated into all macroeconomic textbooks and, to some extent, permeated the beliefs and actions of policymakers. But many of these lessons have been forgotten in recent decades, crowded out of public consciousness by other major economic phenomena, such as the high-inflation 1970s.

The austerity-versus-stimulus debate continues with proponents of austerity point out that the long-term consequences of permanent expansionary macroeconomic policy – both fiscal and monetary – are unsustainable deficits, debt and inflation. Conversely, proponents of stimulus correctly point out that in the aftermath of a recession, when unemployment is high and inflation low, the immediate consequences of contractionary macroeconomic policy are continued unemployment, slow growth, and debt-to-GDP ratios that go up rather than down. Less thoroughly aired recently is the question of whether, given recent conditions, monetary or fiscal expansion is the more effective instrument.

Under the circumstances that held in the 1930s and again today – conditions of high unemployment and low inflation but also of near-zero interest rates – stimulus in the specific form of fiscal expansion is much more likely to be effective in the short term than stimulus in the form of monetary expansion. Monetary expansion is rendered relatively less effective because interest rates can’t be pushed below zero.

Despite the inability of central banks to push short-term nominal interest rates much lower, one should not give up completely on monetary policy, especially because fiscal policy is so thoroughly hamstrung by politics in most countries.  Introductory economics textbooks talk about the Keynesian multiplier effect: the recipients of federal spending – or of consumer spending stimulated by tax cuts or transfers – respond to the increase in their incomes by spending more as well. Again, the multiplier is much more relevant under current conditions than in more normal situations.

A new wave of econometric research estimates fiscal multipliers using methods that allow them to be higher in some circumstances than others. Needless to say, the effects of fiscal policy are subject to substantial uncertainty. Nevertheless, if the question is whether it is monetary policy or fiscal policy that can more reliably deliver demand expansion under current conditions, the answer is the latter. One might even dramatize the contrast by speaking of ‘monetary alchemy and fiscal science’.

Eric Leeper characterized monetary policy as science and fiscal policy as alchemy. It is true that the state of knowledge and practice at central banks, which actually set the instruments of monetary policy, is close to the best that modern society has to offer. It is likewise true that the instruments of fiscal policy are set in a very political process that is poorly informed by the state of economic knowledge and largely motivated by politicians’ desire to be re-elected.

Alchemists were not stupid or selfish. Rather, alchemy fell far short of modern chemistry. The term alchemy could be applied to pre-Keynesians like US officials whose Depression prescription was “liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate ... it will purge the rottenness out of the system”. But in light of all that was learned in the 1930s, it would be misleading to characterize the current state of fiscal policy knowledge as ‘alchemy’.  Perhaps, someone in Washington might learn something.

http://www.voxeu.org/article/monetary-alchemy-fiscal-science

Bank capital requirements: Are they costly?

By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

There exists a view that having banks use more equity capital (and relatively less debt) to finance the assets they hold creates substantial costs, costs that may be so great as to make more capital infeasible. David Miles, in a VOXEU communique (Jan. 17^th), believes that these costs are exaggerated. But the benefits of having banks that are far more robust – in the sense of having a balance sheet structure that makes them much less likely to come near to insolvency once actual and suspected losses on their assets come along – are likely to be large.

Banks used to finance a very much higher part of their activities with equity than is considered acceptable today. Bank leverage before 1970 in the UK was, on average, about half the level of recent decades. Spreads between reference rates of interest and the rates charged on bank loans were not obviously higher then when banks made very much greater use of equity funding. 

There is no clear link between the cost of US bank loans and the leverage of US banks. The significant increase in leverage of the US banking sector over the 20th Century was not accompanied by a decrease in lending spreads, indeed the two series are mildly positively correlated so that as banks used less equity to finance lending, the spread between the rate charged on bank loans to companies and a reference rate actually increased.

Miles made some assumptions about bank returns to determine their cost of capital.  If the required return on equity is set at 15% with a cost of debt of 5%, the weighted average cost of capital would have risen to 5.66% and leverage of 30 times.  If capital is doubled and leverage reduced to 15 times, it might cause the cost of bank funding to rise by between 17bp and 33bp. These numbers are nontrivial but hardly enough to do substantial damage to banks.

A rather more subtle argument is that, while in some circumstances equity is not an exceptionally costly form of finance for banks, today it is because bank equity is trading at a huge discount. One version of this argument is that because the ratio of the market value of equity to its book value is well beneath unity, a bank which raises equity is imposing huge costs on those that provide it.

Another interpretation of the price to book argument is that it shows that required returns on new equity are very high. But a far more natural interpretation is that investors believe that existing assets on a bank’s balance sheet are worth less than their acquisition cost rather than that the required return on new investment is very high.  The fair value of loans should reflect the present value of expected cash flows.

The argument as to why raising more equity capital is problematic for banks is that the benefit of extra capital may substantially accrue to those with debt claims, making it unattractive to new shareholders. This is a debt overhang problem: first, failure to raise more equity is a huge obstacle to a bank being able to function properly with a cushion against losses too low to make it able to raise debt easily; and second, one way to handle the debt overhang problem is to have some debt convert to equity.

What are the people that run banks really saying if they argue that it is very costly – even unfeasible – to use more equity funding? One interpretation is that this argument is an admission that they cannot run a private enterprise in a way which makes people willing to provide finance whose returns share in the downside and the upside. In other words, they are people who will face the full consequences of their commercial decisions to provide funding. It is as if banks cannot play by the same rules as other enterprises in a capitalist economy – after all, capitalists are supposed to use capital. You might expect that if this is the assessment of many people who currently run banks, then they would not wish to proclaim it so loudly. The upside is that bank risks might be priced correctly without a government subsidy.

http://www.voxeu.org/article/bank-capital-requirements-are-they-costly