The simplest solutions continue to escape those trying to fix our broken financial system. Consider banks’ need to have enough capital on hand to weather market storms. Instead of requiring banks to simply raise and hold more common equity—the most important kind of capital—regulators are kicking around more convoluted ideas.
One calls for the creation of a new type of security dubbed “contingent capital”, which would be debt in good times and convert to equity during a crunch. This approach combines financial engineering, complexity and a reliance on more debt—the very things that got banks into their current mess.
Yet the idea was brought up last week by Federal Reserve Chairman Ben Bernanke during Congressional testimony and was echoed by other central bankers such as Bank of England Deputy Governor Paul Tucker.
Why go for something complex when raising equity will put banks on a solid footing? It seems to solve a dilemma for Bernanke and other regulators of how to require banks to raise more capital without coming down too hard on them.
Banks don’t like to hold too much equity because it can damp down returns, profits and, in turn, share prices. During the crisis, banks were hesitant, and in some cases unable, to issue new equity, not wanting to sell stock at what they considered too-low prices or dilute existing shareholders.
During the second and third quarters of 2009, US banks raised almost $50 billion by selling equity to private investors, according to Bloomberg data. While that may sound like a lot, about 70 per cent was raised by 10 large banks like Goldman Sachs Group Inc, Wells Fargo & Co and JPMorgan Chase & Co.
FALLING SHORT
And equity raised by US banks so far in 2009 still falls short of the $60 billion that the 24 biggest banks used in 2007 to pay dividends and buy back stock. Capital raised by US banks of $754 billion since the financial crisis began has also failed to keep pace with writedowns and credit losses of more than $1 trillion, Bloomberg data show. Given their aversion to equity, and regulators’ desire that banks hold more capital, ideas such as contingent capital have gained traction. First, a brief explanation of the difference between equity and capital is in order. Equity is a company’s assets minus its liabilities, its net worth, and serves as a buffer that can absorb losses.
THE BIG IDEA
Capital is a regulatory concept. It expands the idea of equity to include some kinds of debt, or excludes some losses from a firm’s calculation of equity. During the depths of the crisis, investors stopped believing in measures of regulatory capital; they only wanted to know how much tangible common equity—a measure of equity that excludes things like goodwill resulting from acquisitions—a bank had.
Contingent capital is a compromise that helps banks avoid taking on lots more equity in good times, yet creates a reserve for bad days. The idea is also that the debt holders would share some pain alongside shareholders.
There are numerous issues. First, Wall Street for years has gamed capital by coming up with so-called hybrid, quasi-equity instruments. Investors found out the hard way that during a crisis, equity is equity, debt is debt and there really is no in-between.
The method of converting contingent capital into equity also isn’t clear. Should it happen when macro-economic conditions fall to a pre-set point? Or perhaps when a bank’s shares, bonds or financial metrics have signalled stress? Or maybe regulators should decide?
TRIGGER FINGER
Any of those triggers opens up the potential for manipulation or prevarication. It’s doubtful that regulators would allow the trigger to be pulled. “A too-big-to-fail institution will argue that exercising the conversion will shake markets and itself become a systemic event,” said Joshua Rosner, managing director of independent research firm Graham Fisher & Co. Plus, the conversion would be only a temporary fix that actually sends a distress signal to markets.
KEEP IT SIMPLE
Having more equity in the first place eliminates these issues. In fact, the Federal Reserve stressed in an April paper describing the government’s bank stress tests that common equity should make up the bulk of capital.
If more equity reduces earnings, so be it. As Rosner said: “Do we want banks to be safe and sound and grow at reasonable rates of return, or urge them to grow at a very fast pace and potentially run into the rocks every few yeas?” Some contingent-capital supporters, such as Raghuram Rajan, a professor at the University of Chicago, argue equity alone doesn’t do the trick. The temptation, Rajan said during Congressional testimony earlier this year, will grow too great for regulators to permit banks to reduce equity in good times.
That is a reason to force regulators to show some backbone for a change. It isn’t justification for coming up with more engineered financial instruments. To revive banks’ fortunes, it’s far better to keep things simple.
David Reilly is a Bloomberg News columnist. The opinions expressed are his own
