The
regulatory direction for banks is clear enough: more capital rather than less.
Bankers have been pushing back for reasons that, to me at least, defy
comprehension.
Bankers say
higher capital will mean higher borrowing rates, lower credit growth and
diminished investor interest. They are wrong. We need banks to be better
capitalised in order to protect ourselves against bank failures, banking
crises- loss of economic output that stretches out for several years.
It’s
heartening to see that American regulators have seen the light and are pushing
for higher capital norms for banks under Basel 3 regulations.
My article in BS, Will bankers ever learn?
Will bankers ever learn?
T T Ram Mohan
Jamie Dimon, the chief executive
officer of J P Morgan Chase, is that rare banker who doesn’t hesitate to take
on regulators and lawmakers. He was severe in his criticism of the Dodd-Frank
Act that led to stricter regulation
of banks in the US after the global financial crisis (GFC).
Now, Mr Dimon has trained his
guns on the Basel III “end game” rules for banks planned by American
regulators. These are the final rules related to the implementation of the norms widely agreed upon after the
GFC. The new rules will mean higher capital requirements for banks. While Mr Dimon may be gutsy in taking
on regulators, it doesn’t mean
he’s right.
US regulators are proposing several changes in the
way capital requirements are determined under Basel III. They want all banks
with assets exceeding $100
billion to use standardised models, instead of internal models, for providing
capital for credit risk and operational risk. For market risk, these banks will have to calculate
risk-weighted assets using both standardised approach and model-based approaches and use the higher of
the two. In addition, banks will have to reflect unrealised losses or gains on available-for-sale securities. These
and other proposals will cause bank capital to increase, and that’s what we need.
Requiring the use of standardised
models for risk assessment is a huge
shift. In standardised models, risk is assessed based on the average risk
experience. Under Basel II rules, which were
in place until Basel III came into force, the focus was on capturing risks
specific to a bank using Internal Risk-Based (IRB) models. Banks that effectively managed risk would end up having
a capital requirement lower than that required under standardised models, resulting in a higher return on equity.
Only banks that could demonstrate
the robustness of their risk models would qualify for use of the IRB approach.
The very fact that a bank had been approved for the use of the IRB approach
signalled to the markets its superior prowess in managing risk.
Regulators are now having second
thoughts on the use of IRB models. During GFC, it turned out that many of
the banks that used IRB models just did not have the necessary capital to cope
with losses. In drawing up the Basel III norms, regulators judged that placing
too much reliance on IRB models was unwise. They decided to supplement the
earlier capital requirements with a simple leverage ratio, defined as Tier I
capital to total assets, of 3 per cent. This translates into a debt-to-equity
ratio of 33:1. If this seems an absurdly high level of leverage, remember that
banks were even more leveraged
earlier.
With the latest Basel III proposals,
American regulators are changing tack. They would rather not rely on banks’
internal models at all. They aim to
do away with internal models for credit risk and operational risk and play safe with models for market
risk. The Reserve Bank of India (RBI)
has been moving towards estimating credit loss based on IRB models. It may now want
to revisit the proposition.
The underlying principle driving the new US proposals is simple
enough: For banks, more equity capital is better than less. Mr Dimon opposes
the move based on arguments we have been hearing from bankers for years now. Two
American academics, Anat Admati and Martin Hellwig, have devoted a whole book
to showing up the fallacies in these arguments (TheBankers’ New Clothes).
Mr Dimon says more equity capital
will translate into higher lending rates for borrowers. This is based on the
premise that equity is costlier than debt, especially when we take the tax shield for
debt into account. In banking, that is true only because bank debt is hugely
under-priced.
Lenders to banks know that a
large bank will not be allowed to fail (“too big to fail”) and are willing to
lend at a lower rate than would be dictated by the level of debt. There is thus
an implicit subsidy received by
banks considered “too big to
fail”. This is a cost that is borne by the taxpayer. It is only when we
ignore this implicit subsidy in bank debt that it appears as cheap as it does
today. To ignore this is to pave the way for more bank failures and bailouts by
taxpayers.
Mr Dimon also contends that investors
find bank stocks unappetising if capital requirements go up and return on
equity falls. That is not true either. The share price of a bank is a multiple
of the price/earnings ratio (P/E) and earnings per share (EPS). Higher equity
requirements tend to cause the EPS to fall but they result in a higher (P/E)
ratio as investors perceive banks with
higher equity as safer and re-rate
bank stocks with higher equity
capital.
Which of the two effects above
will dominate? Bankers seem to think it is the (P/E) effect that will dominate
and result in higher valuations. What else can explain the fact that the
capital adequacy ratios at the best-performing banks have raced far ahead of the
regulatory minimum?
In the US, capital adequacy at an
International Monetary Fund (IMF) sample
of banks averages over 16 percent, while
the requirement stands at around 11 per cent for most banks and slightly
higher at 16-17 per cent for very few large banks. The averages in the UK,
Switzerland and Sweden are 22, 20, and 23 per cent, respectively. In India,
private banks operate at a capital adequacy of 19 per cent, even though the regulatory requirement
is just 12 per cent. If higher capital is going to cheese off investors, how do
we explain the fact that banks with higher
capital than average also command the highest valuations?
Bankers must be aware of this, so why do they set up a
howl every time the regulatory requirement goes up? One explanation put forward
is that bankers are paid bonuses based on return on equity. The solution, then,
is for boards to change the metric for performance awards from return on equity
to return on risk-adjusted capital. Allowing a high level of debt so as to
show higher return on equity is certainly not the solution
The regulatory trend is in the direction of increasing capital
requirements for banks. That is good for both banks and the economy. The question is: Will bankers ever gracefully accept this reality?
