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Opinion Pieces

Banking and the Shackles of the Capital Ratio

In an online chat group that tracks the banking sector, in a conversation over the poor performance of European banks in the recent stress tests, I was stunned to come across a comment from a contributor who asked the following question: “Can somebody explain me (sic) why it is in the interest of overall society that banks have capital levels to withstand even the worst crisis?”

 

Banking Capital Cliff Image smallTo many, the question must seem borderline subversive. In a post-Crisis world in which taxpayers were forced to bail out the banks, questions like these are generally deemed inflammatory and irresponsible. But the truth is that it is a very good question.

 

Putting aside any political distaste for the banking industry, the logic behind the question is sound. In significantly raising what is known as the CET1 ratio – the ratio between common equity tier one capital and total assets – the Basel regulator has inadvertently radically increased the likehood of failure in banking.

 

Think about it firstly at a systemic level. Requiring all banks to hold more capital means a less attractive banking sector overall from an investment perspective. Increased capital means lower returns on equity, which means lower returns to shareholders. It is therefore increasingly difficult for banks to attract new capital, requiring them to hold back dividends or to issue rights that dilute existing investors.

 

Banks, however, will find little empathy from the public based on this argument. It is only when one looks at the problem of capital at the idiosyncratic risk level, that the chat room contributor’s question becomes more compelling. At an idiosyncratic, individual bank level, the increase in the CET1 ratio has meant that banks have become more risky, rather than less risky.

 

To explain: recall that Lehman Brothers was not the only institution that was holding large volumes of very poorly performing assets – particularly the now much-maligned structure known as the collateralised debt obligation. They were simply the bank that was regarded by their peers as holding the worst of the assets, at least at the point in time when it most counted.

 

It was a little bit like a game of musical chairs, and the institution that happened to be without a chair at the moment when the music abruptly stopped, was Lehman Brothers.

 

All major investment banks at the time were very highly leveraged and all depended heavily on interbank loans and repos made between them to fill in their daily liability gaps. The gentleman’s agreement that existed between them – particularly at an individual trader level within their money market and treasury funding operations – was to always back their peers by providing such funding when it was needed.

 

When panic struck, survival instinct took over, and banks began hoarding cash. This meant that those banks that required roll-over of short term liabilities were exposed. Lehman was more exposed than most, and was culled from the herd. Richard Fuld, the CEO of Lehman at the time, was incredulous. It may be apocryphal but he is recorded to have asked Hank Paulson, the then Secretary of the US Treasury, “Why me?”

 

The Financial Crisis was caused by a build-up of overextended credit in the mortgage market, exacerbated by the construction of unfunded leveraged bets on credit worthiness, but was really jerked into panic mode by the liquidity crisis created in the interbank market.

 

There are few real players in the interbank market, only the big investment banks and some of the large diversified banking groups. And like a game of Texas hold’em, when a player has bluffed on a poor hand and has gone all in, there is no mercy.

 

Consider once again then the risk of raising the CET1 ratio at an individual bank level. Should a disruptive market event occur, the capital requirement within an individual bank will be breached earlier now than it would have been previously. While this individual bank holds now substantially more capital than in a pre-Crisis world, it ironically has a far greater chance of technical ‘failure’. Once it is deemed to have failed – and to be clear the regulatory authorities have made capital breaches very public – all peer banks will shy away from rolling over funding to this miscreant bank. Before the capital buffer – built up over the past eight years under the modified regulations called Basel III – is ever called upon to absorb any potential credit losses, this bank will be out of business owing to a short-term liability shortfall.

 

If one has any doubt about this, simply analyse case-by-case the banks that failed during and post-Crisis. Of the top 1000 banks listed in the Banker magazine for 2007, more than one hundred of them failed or were bailed out. In very few cases did any of these banks burn through their capital. Their declining capital ratios were simply the precursor to the liquidity squeeze that followed.

 

Going forward there is a further deleterious aspect to the raising of the capital bar for banking. To explain: in recently released 2nd quarter earnings reports, European banks have underperformed relative to their US peers. There are several reasons, not least of which is the severe market shock of Brexit. But the two primary reasons are clear. First, that interest rates have declined to unprecedented levels, squeezing margins, and second, that large investment banking groups – Deutsche as a stand-out example – have slashed their investment banking balance sheets over the past several years to increase their CET1 ratio.

 

Deutsche Bank in particular has battled for some time to increase the numerator of the CET1 ratio, appealing to sources such as Qatari investment funds for several rounds of capital injection. More recently, however, in order to ensure that the bank passes stress tests and to appease analysts, their leadership has successively either sold off or allowed natural run-off of existing lending to organically reduce their balance sheet. Either way: a smaller balance sheet means less profit. Their strategy to grow capital-light businesses, such as advisory, also seems to have failed – at least in the short term – owing to generally poor economic activity in Europe, as well as to difficulties inherent in such businesses, where success is dependent on key rainmakers, and chunky deals coming through the pipeline.

 

To return to the chat room contributor’s question: of course the fate of Deutsche Bank as an individual firm – whose largest shareholder is now the Qatari royal family – is probably of little interest to overall society. What is of far more interest to overall society – or at least it should be – is that a bank such as Deutsche Bank – has made a series of strategic decisions, and a series of missteps in the execution of these decisions, that are based primarily on a fear of breaching a new and arbitrary capital requirement level, rather than on sound business rationale. This is bad not because investment bankers will lose their jobs.

 

This is bad because banking is critical to economic growth. Regulators in their fervour have reined in banks, it is true. But they are also now hindering economic growth.

 

 

 

 

 

 

 

 

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