In recent weeks, the battle between bankers and regulators that had been taking place behind the scenes, started to spill out into public view. The reason seems clear: for all of the lobbying they’ve done, banks have been unsuccessful (so far) in weakening the major provisions of Basel III and Dodd-Frank.
To quickly refresh: Regulators want banks to hold higher levels of capital and liquidity in order to mitigate the impact of any future financial crises. More capital equals more stability. Because the largest banks are highly inter-connected and because transparency is still an issue, it has been proposed that these larger banks (the so-called global systemically important banks, or G-SIBs) should hold an extra layer of capital on top of the already-increased capital levels.
The larger banks probably aren’t happy about any of the new regulations, but they seem to particularly dislike what is referred to as the “G-SIB surcharge,” the extra 1% to 2.5% of capital that regulators favor for the world’s largest banks.
To aid in their last-minute lobbying efforts,The Clearing House (TCH),a banking association and payments company that is owned by the world’s largest banks,recently put out a presentation that concludes that the G-SIB surcharge would be, as it says on the link on their home page,“detrimental to fragile U.S. economic recovery.”
In the presentation,however,there is little evidence of any “detrimental”effect to the economy. Nor is there much evidence that such impacts were tested for. Rather, TCH focuses on the impact of the G-SIB surcharge to the banks themselves - largely through their estimated impact to return on equity (ROE), and then postulates what that might mean to bank customers. The problem is, the presentation raises a number of questions that, for me, cast doubt on their conclusions. There are also some other, very detailed reports, that indicate that the G-SIB surcharge would not result in long-term damage to the economy.
To begin with, Key Finding #1 in the Executive Summary of the TCH report states:
“Relative to pre-crisis levels, banks would have to raise an additional 100% more capital, or $525 billion in common equity,to meet Basel III’s 7% common equity capital requirement (from $525 to $1050 billion).”
“If the G-SIB surcharge is imposed,banks will need to raise an additional 66% more capital,or $500 billion,over year-end 2010 levels (from $750 to $1250 billion). This shortfall is approximately as large as all of the capital held by U.S. banks pre-crisis.”
I don’t know if that was intentionally misleading or just convoluted writing - I’m assuming the latter. That quote leaves the impression that banks are being asked to double their capital and then add another 66% on top of that. Not exactly. That would raise the required capital to something north of $1700 billion, not the estimated total of $1300.
This might seem like quibbling, but the G-SIB would add about another 24% of capital on top of the fully phased in Basel III requirements –which equal about a 100% increase. So, from pre-crisis levels (2007), once Basel III is fully implemented, capital will have increased 100%. Larger banks will then be asked to add an additional 24%. Yes,they technically the TCH report does say that the banks will have raised 100% to get to Basel III –and then they go back to 2010 to use that number for the 66% increase –but people read quickly and impressions are what matter.
To be fair, the math is laid out correctly on slide 9, but if anyone just read the first few pages –and many people do –they might get the wrong impression. My guess is that the Executive Summary is about all that many people will read,so it needs to be much clearer. Just lay it out the way it was on slide 9 - that was perfectly clear. I can’t tell if it’s accurate,but at least it’s clear.
On the first page of the Executive Summary they also claim:
“If the Basel Committee’s G-SIB capital surcharge is implemented in the U.S.,these banks would have to either increase the borrowing costs to their customers by 60 basis points (a 15% increase in their net interest margin) or reduce their non-interest expense ratios by almost 11 percentage points (a 19% reduction in expenses).”
Where does this conclusion come from? On slide 9, they say that the increased capital requirements “would reduce bank ROEs by ~430-490 bps. In order to offset this impact on returns, banks would have to increase NIMs [net interest margin] by 40-100 bps or decrease the non-interest expense ratio by 8-19 percentage points.” Did they just take the difference in the range of net interest margin (60 bps) and call this “increased borrowing cost to their customers”? That wouldn’t make sense.
More puzzling, however, is simply how they arrived at their conclusion that bank ROE would decline by 490 bps. There is no clear answer to how they arrived at that figure. On slide 24,they show that Basel III will result in a decline in ROE of 2.9% (or 290 bps),that a 2.5% G-SIB surcharge will take it down another 200 bps, but they don’t show any analysis or indicate how they arrived at their numbers.
In a similar way,on slide 25, TCH shows that, as required capital increases, net interest margin (NIM) increases and non-interest expense falls. Once again,however, they don’t show their work. Also, they show the NIM as a “percent of average assets.” It should be “percent of interest-bearing assets.” Again, I don’t know if that’s a typo or a flaw in the analysis - because they don’t show the analysis.
Still on slide 25. The left-hand column is titled, ”Impact on required return on equity.” Maybe this is where they lay out how they arrived at the 490 bps decline in ROE? Unfortunately, no. The bullet points don’t really deliver. First, they say that they got data from 8 banks - not the 10 that they originally discussed, or the 7 that they used to lay out their stress test analysis. Given the varying number of banks used in different parts of this presentation,I’m already wondering about selection bias. Why, if they have data from 10 banks, don’t they use all 10 banks? Why 7 for this analysis and 8 for that? Shouldn’t there be some consistency?
Then they say, ”the change in cost of equity is found by applying estimates from the academic literature1 to compute change in levered beta.” The academic literature they refer to is a study done by David Miles et al for the Bank of England. I highly recommend it. It is a serious piece of work that lays out exactly how they did their analysis –and it comes to some interesting conclusions, which I’ll get to in a bit.
But first, TCH uses a formula that they say is in the Miles paper: “Specifically: Change in Levered Beta = 0.031*Change in Assets/Equity.” Again…not quite - or,at least, I hope not. The 0.031 they reference is the coefficient of leverage that resulted from a regression analysis that Miles et. al conducted. The regression used U.K. banks and U.K. data. If TCH wanted to show the impact on U.S. banks, I think the appropriate approach would have been to model their analysis after Miles et. al, but not to simply lift a single coefficient from an entirely different set of data. That coefficient is specific to that data set –it’s not a universal.
Here is a spoiler alert for those who plan to read Miles et. al: Their finding on ROE is that decreasing bank leverage from 30 to 15 results in a decline in required ROE of 2.25% (from 14.85% to 12.6%). Required ROE is the return that shareholders are expecting for the risk they are taking. Why the decline? Because,as leverage falls, so does risk. And as every MBA student knows,the lower the risk of an investment,the lower the expected return.
I don’t know about you,but my first concern is not the bank’s profitability or ROE - it is the bank’s stability. It is only with a stable financial sector that we can enjoy sustained economic growth - and I speak as both a former banker and a current bank shareholder - boring is fine with me.
I promise not to get bogged down in the minutiae (too much),but I am wondering if anyone at the TCH read the Miles paper. If they had, they might have seen this on page 4: “We conclude that even proportionally large increases in bank capital are likely to result in a small long-run impact on the borrowing costs faced by bank customers….But substantially higher capital requirements could create very large benefits by reducing the probability of systemic banking crises.”
TCH says:“We believe that Basel III’s capital requirements,without a G-SIB surcharge,would promote a safe and prudent banking system.” I’m relieved to know that the TCH report does at least support the increased capital requirements of Basel III. But Miles et. al take it further and support even higher levels. This is the last line of their abstract:
“We find that the amount of equity capital that is likely to be desirable for banks to use is very much larger than banks have used in recent years and also higher than targets agreed under the Basel III framework.” Note that this paper was published prior to the release of the 1% –2.5% target range for the G-SIB surcharge.
More from Miles et. al (page 41):
“We believe the results reported here show that there is a need to break out of the way of thinking that leads to the “equity is scare and expensive”conclusion. That would help us get to a situation where it would be normal to have banks finance a much higher proportion of their lending with equity than had been assumed in recent decades to be acceptable. And that change would be a return to a postion that served our economic development rather well,rather than a leap into the unknown.”
Remember, the point of these new regulations is for banks to raise capital levels - primarily with common equity - to make them safer. There are several ways to do that. Banks could go in the markets and issue stock,but that’s expensive. They could grow their capital organically with profits because net income (minus dividends) gets added to retained earnings –which is common equity. So, the higher the net income, the faster capital builds - all else equal.
Finally,banks could sell assets. The benefit of an asset sale is that the profit from the sale (the net income) would help to build the capital base. If you’ve been reading the papers, you have probably noticed that banks are beginning to do this. Generally,such asset sales also help by lowering the risk-weighted assets (another component of the capital calculations), but that’s another story for another day.
Here is one last quibble I have with the TCH study. Although asset sales are a viable alternative to raise capital and lower risk, and despite the fact that banks are starting to do this, the TCH conclusion on declining ROE excludes this impact (“Analysis does not consider likely business model changes.” slide 24). That’s a pretty big variable to ignore.
I do recommend the Miles et. al paper because they make an effort to account for both the cost and benefit of requiring higher capital levels from the banks. I would love to see a similarly detailed report from the banks.
For those of you who want another take,check out this report,that was just released by the Bank for International Settlements (BIS). Their conclusions also favor the G-SIB surcharge (unsurprisingly,since they’re the ones calling for it) - but they also include plenty of data and formulas for you to chew on so you can decide for yourself what you think about their claims.