Bank capital is not a magic risk cure

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Bank capital

On Monday, the Federal Reserve’s vice-chair for bank supervision, Michael Barr, gave an important speech. It was not important because it broke news. Despite proposing a set of regulatory and supervisory changes that will significantly diminish many banks’ profit profiles, bank stocks did not budge in response. The broad outlines of the changes, based on the Basel III international framework, have been knocking around for a while. What was important was what the speech revealed about the Fed’s regulatory philosophy. To exaggerate slightly, Barr thinks higher capital cures all ills, and he’s wrong.

The meat of the speech advocated changes to the way banks’ risks should be assessed, and therefore the amount of capital that they must hold. Credit risks should be measured in a standardised way, rather than allowing banks to use internal models. On trading risk, “quality standards” should be imposed in banks’ internal risk measures, and risk should be measured at the product or trading desk rather than at the holding company level (this change likely increases requirements because some risks cancel each other out at the firm level). Finally, operational risk would also be measured in a standardised way (operational risk is the risk of malfeasance or incompetence — a crooked banker lands his bank in litigation, a dumb banker loans a lot of money to Bill Hwang, and so on). And all of these rules, Barr says, should be applied to all banks with $100bn or more in assets.

Barr estimates that these changes (plus a few others) would end up requiring banks to hold an additional two percentage points of capital. This is a lot. Schematically, a bank that has an equity capital ratio (capital/assets) of 10 per cent and return on assets of 1.5 per cent has a return on equity of 15 per cent. Add two more percentage points of capital to that bank, and return on equity falls to 12.5 per cent. That is a big fall in profitability.

Banks hate all this, but they knew that it was coming (and that much of it will probably get pushed through). Perhaps anticipating this, and the political resistance it will inspire, Barr emphasised this spring’s collapse of Silicon Valley Bank, First Republic Bank and Signature Bank right at the top of the speech. He also argued that one of his proposed changes — including losses on “available for sale” securities in bank capital — might have helped prevent the collapse of Silicon Valley:

Realising the losses from these (AFS) securities, without adequate capital to protect from those losses, was an important part of the set of events that triggered the run on Silicon Valley Bank. If the bank had already been required to include those losses in its reported capital, it is less likely that the market and depositors would have reacted the same way. Furthermore, banks that were required to reflect unrealised losses on AFS securities in regulatory capital managed their interest rate risk more carefully, suggesting that the requirement to include gains and losses on AFS securities in regulatory capital leads to stronger risk management as well.

This is almost complete nonsense. For one thing, most of the security losses at SVB were in its “held to maturity” portfolio, not its AFS portfolio. For another, neither the proposed changes to the treatment of AFS securities nor any other of the changes outlined in the speech would have left SVB with anywhere near enough capital to withstand the depositor run it faced. As Charles Peabody of Portales Partners put it to me, SVB was killed by “a combination of poor management and illiquidity . . . no one survives $42bn in withdrawals in one day. Barr has yet to provide a justification for what he is doing.”

Finally, it is not clear (to me, anyway) why changing AFS accounting treatment or raising capital requirements would incentivise banks to manage interest rate risks better. When Barr said that “banks that were required to reflect unrealised losses on AFS securities in regulatory capital managed their interest rate risk more carefully”, who was he talking about? Not Bank of America, which because of its size laboured under more rigorous AFS treatment, and yet still managed to accumulate $100bn in losses by buying tons of long-term securities when rates were low. 

As Brian Foran of Autonomous Research puts it, Barr’s proposals “dance around the core issues” behind this spring’s mini-crisis, such as uninsured deposits, held-to-maturity securities, and rate risks. The best we get is a promise to address these issues later.

This brings us to the core philosophical tenant of the Barr speech, which is that in bank regulation and supervision, more capital cures all ills:

[C]apital is what allows the bank to take a loss and keep on operating. The beauty of capital is that it doesn’t care about the source of the loss. Whatever the vulnerability or the shock, capital is able to help absorb the resulting loss and, if sufficient, allow the bank to keep serving its critical role in the economy. Higher levels of capital also provide incentives to a bank’s managers and shareholders to prudently manage the bank’s risk, since they bear more of the risk of the bank’s activities.

But Silicon Valley and First Republic had adequate capital, and they got shocked right out of existence, largely because its managers and shareholders were massively imprudent.

Nor is it obvious that the US banking system as a whole is undercapitalised. As Steven Kelly of the Yale Program on Financial Stability pointed out to me, one striking thing about the recent mini-banking crisis was that the capitalisation of the big banks — the so-called GSIBs — was never in the least bit of doubt. No one, as far as I know, ever worried about the capital adequacy of the system as a whole, either. Barr and his colleagues have a lot more explaining to do.

One good read

Some advice for young doctors: specialise in the diseases of the rich.