If one point of agreement emerged in the dissonant, post-crisis financial regulation debate, it’s that US banks had far too little capital on hand before the 2008 meltdown. The most highly indebted investment banks, like Lehman Brothers, had borrowed some $40 for every $1 invested, leaving them brittle and vulnerable to the blow dealt by the sudden decline of house prices. But try narrowing down what those in the financial sector, bankers, and regulators actually mean by “capital” these days, and their answers quickly devolve into jargon-larded mumbo-jumbo. Terms like Tier-1 common equity, contingent securities, and risk-weights are bandied about within the industry as if to alienate the non-specialist.
That ambiguity is all too salient as we approach the sixth anniversary of the Dodd-Frank financial reforms. With time, it has become clear that the law was a rather meek first step toward safeguarding the banking system—many of its provisions are still being debated or implemented, and presidential candidate Donald Trump has vowed to reverse most of it.
Increasingly, regulators are coming to believe that banks must have a lot more capital on their books. And research suggests stable and well-funded banks are better able to continue lending even when economies and financial markets come under stress. “Ensuring that banks have enough capital to support their lending activity is vital,” said Hyun Shin, chief economist at the Basel, Switzerland-based Bank for International Settlements, the epicenter of global bank rulemaking. “A bank with plentiful … funds [of its own] is able to borrow more from its creditors, and on much better terms,” Shin told a European Central Bank conference in Frankfurt, Germany, on April 7.
Wall Street, however, feels differently. By muddying the debate over bank capital since the financial meltdown of 2008, it scored its most successful, and potentially harmful, regulatory coup de grace. It managed to portray higher equity requirements as coming with a high social cost that hampers lending and stymies economic growth. This opacity is deliberate. It gives Wall Street a singular advantage in setting the rules by taking key issues like how heavily banks should rely on debt—given the possible need for taxpayer bailouts, for instance—largely out of the public arena.
The industry’s misappropriation of the debate surrounding bank capital predates Dodd-Frank. It goes back to the 2004 Basel II standards for bank capital, which allowed large global banks to go on a borrowing binge leading up to the 2008 debacle. At the time, so-called risk-weights, which let regulators decide which types of debt should be considered so safe as to be treated as equivalent to equity capital, were all the rage. The results were disastrous.
Banks that had been counting on housing-related assets as essentially substitutes for cash discovered the AAA-rated bonds were suddenly worth effectively nothing, since there were no longer any buyers as the panic heightened. This happened again in Europe, as banks that had loaded up on “safe” government bonds from countries like Greece and Portugal needed to fall back on taxpayer help once the value of those securities plummeted.
“Through this risk-based capital regime [regulators] decided what was risky and what wasn’t. And they were wrong; they were completely wrong,” Sheila Bair, former head of the Federal Deposit Insurance Corp., said in a speech in May. “In Europe they said sovereign debt wasn’t risky. In the United States we said mortgage securitizations [the bundling of mortgages and other types of debt for resale] weren’t risky, and that credit default swaps [a derivative instrument used to hedge against the risk of a firm’s or country’s default] weren’t risky, and actually that credit default swaps were somehow reducing risk.”
The confusion over terminology started to bother Stanford University finance professor Anat Admati shortly after the financial crisis in 2009, as politicians and regulators gathered in Washington to hash out what became Dodd-Frank. “If capital is falsely thought of as idle cash, the discussion of capital regulation is immediately derailed by imaginary trade-offs,” Admati says. Here’s what it comes down to:
If capital is money you have to “set aside,” this suggests it’s money you can’t loan; therefore, the thinking goes, it hurts growth and credit. But this is not the case.
If you say capital is money you have to “set aside,” then this suggests it’s money you can’t loan; therefore, the thinking goes, it hurts growth and credit. But this is not the case. Banks can make loans from their debt or their equity.
Many regulators, market analysts, and major financial publications are guilty of referring to capital as something that must be stuffed under the mattress. It’s hard to miss headlines like this one from the Financial Times in July 2015: “Banks urged to set aside more capital for interest rate risk.”
The misunderstanding—or misinformation—reaches the upper echelons of Wall Street. Witness the either misleading or deeply ignorant statement made by Wells Fargo CEO John Stumpf to the Financial Times in June 2013 suggesting his customers’ savings accounts and other deposits were his to spend—apparently forgetting they are actually a liability on his balance sheet, not an asset. “Because we have this substantial self-funding with consumer deposits we don’t have a lot of debt,” he said.
Stumpf’s statement, intentional or not, is a testament to how accustomed Wall Street has become so accustomed to taking risks with other people’s money—bankers almost forget it belongs to someone else. And the more indebted a bank, the more fragile and exposed it will be to even a modest downturn in the economy or asset values.
“It is disturbing that regulators and academics, who should know better, routinely collaborate with the industry to obscure the issues by using the misleading language and failing to challenge false statements,” Admati argued late last year. “If instead the language … focused attention properly on funding and indebtedness, the debate would be elevated and more people would be able to understand the issues.”
Instead of saying “hold” or “set aside more capital,” terms that create the wrong impression, Admati says regulators should call on banks to rely less on borrowing, helping to prevent the financial services industry from co-opting or obfuscating the meaning of the term.
Here it’s instructive to compare the balance sheets of non-bank corporations and their Wall Street counterparts. “It’s rare for corporations to maintain, on a regular basis, less than 30 percent equity relative to their total assets,” Admati says. Take Walmart, the largest US retailer. It has total liabilities of $119.4 billion, but financial markets value its total outstanding equity at $208.8 billion—more than enough to cover potential debts. How about Apple? Its shares have a total market value of $533 billion, compared with the company’s $174.8 billion in liabilities.
Now for a look at Bank of America. Its total market capitalization is just $141.1 billion. Outstanding liabilities? A whopping $1.9 trillion. Citigroup’s reliance on borrowing is similarly eye-popping: only $138.3 billion in equity against total liabilities of $1.5 trillion. And these figures probably understate these banks’ indebtedness since they are masters of hiding liabilities through off-balance sheet transactions using derivatives, as the financial crisis revealed in stark relief.
Proponents of much higher capital requirements think they will naturally force markets to break up inefficient institutions, since the implicit subsidy received—arising from the view that they are backed by the government—would gradually fade. Others have argued that the largest institutions must be actively dismantled so they no longer threaten financial stability. Whatever the ideal solution, getting the language right is a prerequisite for effective regulation. So it’s worth defining some terms to help prevent them from being manipulated to the industry’s advantage.
At its most basic, capital is money to burn, cash invested without the expectation of repayment. That’s why it’s so useful—there are no strings attached. But Wall Street has concocted all types of debt it wants to count as a cash-equivalent, and regulators have bought fully into the notion.
First, there’s “contingent capital,” also known as “coco” bonds. These are debt securities that are supposed to convert to equity in times of stress. It’s not hard to see why these are a terrible idea: The conversion trigger merely accelerates the depletion of capital rather than offsetting it. Second, there’s “risk-weighted capital.” This is basically equity plus stuff that bankers would love to treat as capital even though it really isn’t. That includes debt instruments deemed very safe, like government bonds. But before the financial crisis, it also included AAA-rated housing bonds that turned out to have little or no value.
“I think we should scrap risk-based capital,” Bair said in May. “Just have a stress-testing process and a leverage ratio”—the proportion of debt a bank holds relative to its outstanding equity. She said the complexity of Dodd-Frank, which clocked in at a hefty 848 pages, benefited large banks.
To complicate matters further, regulators use terms like capital “buffer” or “cushion,” which again reinforce the notion of money being set aside and therefore taken out of the pool of funds available for lending and investment. Another jargon-filled acronym favored by the industry is TLAC—total loss-absorbing capacity.
But the bottom line, according to the top thinkers in finance, is clear: Capital is equity, and equity is capital. Everything else amounts to putting lipstick on the proverbial pig. Obfuscating the debate will only hasten the next financial crisis.