Those of you who have seen the movie Speed will remember that Dennis Hopper (the villain) would call Keanu Reeves (the hero) and start the conversation with the phrase “Pop Quiz, Jack.” Given the recent lecture to Chairman Bernanke by Jamie Dimon and the Republican roasting of Governor Tarullo at a hearing last week about the dangers of too much regulation and too-stiff capital adequacy requirements, it is time for a “pop quiz” for the House Financial Services Committee and Mr. Dimon:
“Name one bank or banking organization that has failed because it held too much capital or was driven out of a market by competition because it was too well capitalized.”
I am not aware of a single institution headquartered in the US that would meet either of those criteria.
If that is the case, what’s the problem? Part of the problem is lack of knowledge of basic finance and a fixation on the cost of capital. The reasoning goes as follows: A higher capital requirement means that existing profits are spread across a wider capital base, lowering the return on equity. This in turn adversely affects a firm’s stock price. But what is missing from this formulation is the recognition that “other things are not always equal.” That is, a well-capitalized institution is likely to have (a) a lower cost of capital, (b) a lower cost of debt, (c) greater profitability, (d) lower risk, and e) larger market capitalization than one that is less well-capitalized. The classic case of this was Wachovia, before it was merged into First Union, when John Medlin was CEO back in the 1980s and early 1990s. At that time, the firm was regarded as “acquisition-proof” because of its strong capital position, earnings, and large market capitalization relative to other banking organizations. Any proposed acquisition would have diluted the seller’s shareholders such Wachovia and its shareholders would have effectively controlled the resulting company.
But this view about the relationship between capital, cost of debt, and profitability is not solely based on an anecdote. It is also rooted in scholarly research. Admittedly, some of the work is contradictory, but the better-done studies support the view that higher capital is not an anathema to profitability.
One of the problems with many of the studies, and one that is symptomatic of the kinds of arguments that Dimon and others make, is the failure to recognize the importance of government-contributed capital because of too-big-to-fail. This problem is particularly true for Europe, which virtually has nationalized its banks, used significant taxpayer money to shore up its institutions, and faces the likelihood that even more taxpayer funds will be needed as the Greek debt problem is unwound.
Because of government backstopping and implicit guarantees, policies that were only reinforced during the crisis, large, complex institutions have every incentive to lever up. Both the institutions and the market understand that large banks can operate with higher leverage and a lower capital cushion because they effectively have a call option on taxpayer contributions when needed. Furthermore, institutions don’t have to pay for this implicit capital, which frees up the ability to return profits to their private shareholders. This call option is a form of contingent capital, but not the kind envisioned by the proponents of contingent capital obligations as a way to bolster institutions’ capital positions. It is ironic that, faced with the prospect of the need to call on taxpayer capital to support their troubled institutions, European banking supervisors have pushed off far into the future the actual implementation of new, higher capital standards. They should be doing just the opposite, in order to protect their taxpayers.
Finally, a word is in order on the recent trend, again coming mainly from Europe, to supplement higher capital standards with specific liquidity requirements. What that movement fails to understand is that assets are only liquid, and that liquidity can only be drawn upon, if there is a willing buyer on the other side. During this financial crisis, one of the main problems was the lack of a willing buyer, a role that was ultimately filled by the Federal Reserve and other central banks at a huge subsidy. This suggests that banking on liquidity as a means to solve a problem may be illusory. Yogi Berra might have put it as follows: “Liquidity is what you have when you don’t need it, but when you need it, you don’t have it.”
