The Capital Paradox

The conventional wisdom among international banking regulators is that the best way to improve bank solvency is for banks to increase their capital ratios. While logical on the surface, this concept neglects a significantly more important issue — the quality of the capital banks use to buttress their balance sheets.

In fact, regulations aimed at increasing bank capital may have the unintended consequence of raising the overall risk profile of the global banking industry. This is especially true under current circumstances.

Banks have two sources of primary equity capital (or shareholders’ equity). These are paid-in capital, which is formed through the sale of stock in the bank, and retained earnings, which is the after-tax income left over after dividends are paid out. Banks are directly accountable to shareholders in servicing these two aggregates. And therein lies the rub.

Shareholders tend to be quite demanding in terms of the returns they expect for the use of their equity capital. Even in today’s distressed markets, the average return-on-equity for the fifteen largest profit-making banks in Europe and the United States is just over 10%.

This means that shareholders expect banks to earn roughly 9% per year over the risk-free rate on the capital they provide. This is a tall order indeed, given the currently hobbled state of the European and American banking industries.

But also consider this. At year-end 2006, just ahead of the onset of the real estate crisis, the average return-on-equity was 20.8%, a rate of return not that much higher than it had been over the ten years prior.

To achieve these kinds of returns, banks must adopt one of two options (or a combination of the two). The first option is to raise prices on their products and services. This means charging higher rates of interest and more fees.

The problem, however, with higher interest rates and higher fees is that they tend to suppress demand for bank products and reduce economic activity. This is generally reflected in the profit and loss account, where lower volumes mean lower overall profits. Furthermore, the more consumers of credit get squeezed by higher rates, the more likely these consumers are to default on their loans.

The other alternative is for banks to deliberately raise their risk profiles, both in terms of asset quality and leverage. Banks are paid to assume risk — and the greater the risk, the greater the reward. The need to service capital at ever-higher levels literally forces banks to assume greater risk.

This phenomenon was the root cause of the recent real estate crisis in the United States, as well as other crises that have afflicted the global banking system over the past several decades. In the real estate crisis, banks had no alternative but to play the game in order to meet shareholder expectations.

Servicing shareholder expectations puts significant stress on a bank’s management, because it is the single most important measure of management’s performance. A bank CEO who outperforms his peers by delivering higher returns on capital is rewarded with a higher share price and easier access to yet more capital.

It means a bigger bonus for the CEO and more value in the stock options he’s got socked away from previous bonuses. On the other hand, a CEO who underperforms in delivering return on capital gets fired.

In making demands of management, the shareholder is dispassionate and often unwilling to accept anything but improved year-on-year performance. The chart must go up or the shareholder will express discontent by unloading the bank’s shares, thereby depressing the share price and disadvantaging the bank and its management as they vie for more capital to support growth.

There are voices in the banking community — and among shareholders too — who suggest that banks should eschew excessive risk. But lower risk inevitably results in lower returns-on-equity. And shareholders, unlike bondholders, are nearly unanimous in favoring returns over safety, especially in the types of go-go markets that precede the bursting of a bubble.

This is the essence of the capital quality issue. Banks raise money from detached third parties, who play a relatively insignificant role in the governance process. Rather than analyze bank performance over the long term, these “portfolio” investors look for more immediate quarter-on-quarter gratification. And voting the shares by selling them is the easiest way to achieve that gratification, especially in modern electronic markets where there is little or no cost friction entailed in unloading and reloading positions.

Banks don’t need more detached capital. They need a reasonable amount of involved capital. One method of achieving this is to tie executive compensation to long-term bank performance in a way that mimics a partnership.

Of course, bank managers can amass great wealth in this way, but in doing so they won’t be quite as willing to put their partnership capital at risk in the same way they might be willing to crank up the risk to put their stock options “in the money.” A mandated core of such responsible capital would serve as an effective offset to the more capricious tier of outside capital.

Beyond this, regulators should pay closer attention to diminishing risk through the imposition of policies and limits. Problems at banks do not occur when banks assume risk. Assuming risk, after all, is their primary business. Rather, problems occur when banks assume too much risk in a particular asset, as was the case with commercial real estate in the early nineties and residential real estate in the late zeros. Had limits been imposed on these assets, risk would have been curtailed in both cases and the disastrous bubbles that developed might very well have been prevented.

A quick look at the European debt crisis gives an insight into why more capital is not necessarily the best approach. If European banks were to take an average 20% haircut on their holdings of Greek, Italian, Spanish, Portuguese and Irish debt, nearly double the total capital of all European banks would be wiped out. Increasing capital by a couple of percent would have done nothing to mitigate the damage.

On the other hand, if bankers were risking their own money instead of other people’s, they may not have been quite so willing to assume such lofty risk. By the same token, if they were constrained from taking on risk in excess of a certain limit, the risk would be diminished. More capital from detached sources accomplishes neither objective.

It is a matter of great urgency that policymakers get the issue of bank capital right. Now, with the U.S. and European banking industries suffering from substantially weakened balance sheets, the wrong move could prove disastrous to global economic growth and well-being.

The ideas coming out of the Bank for International Settlements on the issue are worthy, but Basel III in its current form is unlikely to do the trick — and may in fact produce the exact opposite of its intended result.