Today we published a comment on ever-increasing bank capital levels and why the emphasis on bank capital will not lead to greater financial stability. Since the market's valuation of loan "risk" can still only be measured on a daily basis in US markets, but, even then, only after the fact, the whole concept of "risk-based" capital (proposed in 1969 and first implemented by Volcker and Isaac) remains fundamentally flawed. Because "risk" is necessarily quantified and variable, based almost entirely on market-determined credit spreads, until we stabilize market spreads, "risk" is not a controllable matter. By their nature, moreover, whenever market spreads stabilize they become inherently unstable and the more stability is relied upon the greater the risk of error and crisis becomes. This is the central truth of the 2008 crisis, namely that entrophy is the operative model for financial markets, not static measures such as book capital.
You can read the full note with charts below on the KBRA web site:
Since the 2008 financial crisis and the passage of the Dodd-Frank legislation two years later, global financial regulators have been pushing a deliberate agenda to increase the capitalization of large banks. The objective of this increase in capital, we are told, is to make public rescues of the largest banks less likely and to change their corporate behavior. Despite the fact that the 2008 financial crisis was not caused by a lack of capital inside major financial institutions, raising capital levels has become the primary policy response among many of the G-20 nations and the prudential regulators who oversee global banks.
Most recently, Federal Reserve Board Governor Daniel Tarullo revealed on Bloomberg TV (June 2, 2016) that he is "quite confident" that the eight largest U.S. banks will get hit with an additional capital surcharge that will translate into a "significant increase" in capital. However, he noted that there will be "some offsets in other parts of the stress tests so that it won't be just a straight addition of the surcharge." Tarullo opined that he doesn't think the charge will go into effect for the next round of tests, and instead there might be a "phase in."
Part of the problem with using capital as a broad prescription for avoiding rescues for large financial institutions, aka “too big to fail”, is that this approach explicitly avoids addressing the actual cause of the problem, namely errors and omissions by the officers and directors of major banks that undermined investor confidence. A combination of poor loan underwriting, excess risk taking in the trading and investment portfolios, deliberate acts of deceit, a systemic failure to disclose the true extent of bank liabilities, and/or acts of securities fraud actually caused the failure of or need to rescue institutions such as Wachovia Bank, Washington Mutual, Lehman Brothers, Bear, Stearns & Co American International Group (NYSE:AIG) and Citigroup (NYSE:C), to name but a few. These rescues or events of default were driven by a sharp decline in liquidity available to these obligors and led to the wider financial crisis in 2008 and beyond.
Thus when regulators and policy makers sign on to the idea of higher capital levels as a solution for TBTF, are we not all effectively burying our collective heads in the sand? In mid-2008, when Wachovia was receiving inquiries from bond investors about early redemption of long-term debt, the bank’s stated level of balance sheet capital was not at issue. Instead, investors, counterparties, and corporate/institutional depositors were concerned that they no longer understood or trusted the bank’s asset quality and financial statements, and therefore backed away from any risk exposures with the bank. This is also why the Federal Reserve Board and Treasury chose to conceal the true condition of Wachovia from the FDIC, as former FDIC Chairman Sheila Bair documents in her 2013 book.
Bottom line: By focusing much of the attention of regulators and policy makers on the static issue of capital, we are not addressing the true qualitative, behavioral issues that undermined investor confidence in all types of financial institutions and led to the 2008 financial crisis. More, the lack of prosecutions of officers and directors of major banks has fanned the flames of populism, both in the US and around the world. The decision by the Bush and Obama Administrations not to prosecute those responsible for the 2008 financial crisis may have political consequences for many years to come.