Capital backflip puts banks’ health in focus

The Bank of England’s move on British banks’ minimum capital levels has refocused attention on the world’s banks.

The Bank of England’s surprise decision to reverse a tepid planned increase in British banks’ minimum capital levels yesterday, with the aim of maintaining lending in the wake of Brexit, has refocused attention on the health of the world’s major banks. Italian bank share prices have slumped more than 25 per cent since late June, as reports emerge that more than 15 per cent of their loans are delinquent. Mark Carney’s decision comes less than a week after the IMF singled out Deutsche Bank as a threat to the global financial system: massive, complex, and woefully undercapitalised.

The Federal Reserve last week gave the broad tick of approval to the capital adequacy of the US’s biggest banks for the sixth year in a row: only two out of 33 banks failed (including the US subsidiary of Deutsche), and even then only marginally. But the biggest US banks’ equity prices are down more than 10 per cent too, over the past month.

As bank stocks reel despite regulatory reassurances, it’s worth remembering the insights of late University of Chicago economist George Stigler, who won a Nobel prize for showing how government regulation tends to serve the interests of the industry being regulated. Maybe banks aren’t so sound.

While regulators on both sides of the Atlantic tout what they consider the progress made since 2008, very little has changed in the structure of banking since the crisis. The nine biggest US banks had about $6 of capital for every $100 of assets in December last year, only about $2.50 more than their average level before the financial crisis, according to Federal Deposit Insurance Corporation data. Australia’s big four banks, for the record, have about $5.40. The big European banks have far less.

While that is a big proportional jump from where banks had been, it’s still well below the level advocated by eminent financial economists, including Nobel prize winners William Sharpe and Eugene Fama — neither renowned anti-free market warriors — who have argued banks’ capital levels should be at least three times greater to protect taxpayers from bailouts and curb the insidious implicit guarantee that subsidises bank revenues. For them, and many others outside the employ of banks and regulators, the Fed’s pass mark is far too low.

Central bankers believe capital ratios around 3 per cent or 4 per cent are enough. In any case, they prefer “risk-weighted” measures of capital adequacy, which, the Fed has noted, have increased from 5.5 per cent in 2009 to 12.2 per cent this year for the largest bank holding companies in the US — a starker improvement. Risk-weighting allows banks to mark down the value of their assets according their perceived level of riskiness. Mortgages and government debt require less offsetting capital than business loans, for example. This is one reason why Greek government debt and subprime mortgages were so popular before the financial crisis.

Their detractors argue that leverage ratios — which is simply high-quality equity divided by assets — were a better predictor of bank failure. They are more robust too: assigning risk-weights entails making arbitrary assumptions about the relative riskiness of bank assets in the future. It also fosters a multi-billion-dollar “risk-optimisation” industry that helps banks minimise their capital levels within the rules.

As FDIC vice-chairman Thomas Hoenig put it recently: “As long as regulators are complicit at assigning weights for a bank’s measurement of risk and its internal allocation of risk capital … they perpetuate a moral hazard whereby investors rely on the regulators’ approval of bank capital levels and structure.”

Stress testing has a sorry record, too. Before helping blow up the financial system, Fannie Mae and Freddie Mac were given all-clears in the 1990s and 2000s. Three months before the Icelandic banking system collapsed in October 2008, the International Monetary Fund said it was “resilient”. The European Union’s 2011 stress tests passed Dexia and Bankia, not to mention the entire Cypriot banking system, before they imploded.

None of this would have surprised Stigler, who might have cheekily suggested that regulators’ preference for formal stress tests and complex risk-weighting was motivated in part by a desire to justify their jobs. Financial regulation now runs to tens of thousands of pages and the annual stress tests require countless hours of assessments.

Deutsche Bank is not being unfairly picked on. It is more like a giant hedge fund than a bank: less than a quarter of its €1.74 trillion ($2.6 trillion) in assets in March were loans to households and businesses, a markedly smaller share than most banks. Instead, a complex tower of derivatives dominates its balance sheet, leaving a gross exposure of almost €42 trillion, or 14 times Germany’s GDP. The bank could never lose that much: these contracts to pay other institutions “net off” to a market value of around €18 billion. But such reassuring accounting assumes no contractual hiccups and the continued solvency of Deutsche’s counterparties — brave, perhaps, after the crisis.

Investors seem to think so: the bank trades at a value around one quarter of its book value.

Globally it would have failed the Fed’s stress test, too, which required a minimum leverage ratio of 4 per cent in the case of a recession scenario. In fact, Deutsche had less than $3.40 of high-quality capital for every $100 of assets in March. That’s about half as much as the big US banks currently have, and the lowest among the 18 largest non-US banks in the world according to FDIC data.

Despite all risk, complexity and extreme leverage, Deutsche Bank, whose top 181 staff earned €343 million last year, produced a return on equity of 1.4 per cent in March, following a minus 10 per cent result last year. At least shareholders enjoy a sliver of the revenue. German taxpayers are simply on the hook should anything go wrong.