1 a Regulatory Capital Ratio Rule for Financial Institutions Roger Craine

A Regulatory Capital Ratio Rule for Financial Institutions

Roger Craine Professor of Economics University of California, Berkeley CA [email protected]

Vance L. Martin Professor of Economics Melbourne University, Melbourne Victoria [email protected]

April 2015

A Regulatory Capital Ratio Rule for Financial Institutions

At one level, the story on capital and liquidity ratios is very simple: From the viewpoint of the stability of the financial system, more of each is better. … But at what level should capital and liquidity ratios be set?

Stanley Fischer, Martin Feldstein Lecture July 10, 2014

Abstract This paper gives an answer to Fischer’s question and proposes a regulatory capital ratio rule.

The government guarantees financial institutions debt and bails out systemically important financial institutions if they get in trouble. The government protects banks because the failure of a systemically important financial institution creates a negative spillover that causes losses to the economy much larger that the private losses to the bank’s equity and debt holders’. But the government protection is a subsidy to private financial institutions that encourages them to hold excessive debt—which makes them excessively risky. An appropriate regulatory capital ratio is high enough to discourage excessive risk taking by financial institutions and low enough to encourage their intermediation and lending function and at the same time protect taxpayers from private financial institutions’ losses. It’s a delicate balance.

Introduction

In July of 2008—three months before the Lehman Brothers bankruptcy led to the panic freeze of financial markets—the average capital/asset ratio for the twenty riskiest US financial institutions1was 5.6%. Lehman held less than 2% capital. Freddie Mac and Fannie Mae, which the government took over, had 0.6% and 1.5% capital. A small decline in asset value and many financial institutions were insolvent. Government bailouts or massive failures and the collapse of the financial system were inevitable. In October 2008 Lehman failed and in November the US Congress quickly passed the $¾ trillion Troubled Asset Relief Program (TARP) to bailout the banks. Thanks to the bailout the banks survived, but the real sector is only beginning to recover—US per capita real GDP was up only 4% six years after the collapse. And Europe suffered worse than the US.

The financial sector panic and the worst recession since the Great Depression spurred financial regulatory reform—the 2000 page Dodd-Frank act in the US and Basel III (since Basel I & II didn’t work) for international banks. Basel III introduced a minimum “leverage ratio” that requires banks to have common equity that is 3% of assets2, and the US Federal Reserve said they would impose a minimum

1 According to VLab—see Section III for details on VLab. 2 The traditional definition of the leverage ratio is assets/equity so Basel III “leverage ratio” is the reciprocal of the traditional definition.

2 leverage ratio3 of 6% on eight systemically important banks. These are not onerous regulatory capital ratios. But what’s most unusual is that it’s a requirement. No institutions other than financial institutions have capital requirements. This paper presents a quantitative institution specific regulatory capital ratio rule.

Section II reviews why FIs need regulatory capital ratios: governments explicitly, or implicitly guarantee FI debt because the failure of a systemically important institution leads to widespread losses that are far greater than the losses to the institution’s equity and debt holders. But the debt guarantee is a subsidy to FIs that encourages them to hold excessive debt which makes them excessively risky. An appropriate RCR makes the FIs less risky—that’s the point—and reduces the value of the subsidy. Section II also summarizes Admati and friends (2011, 2013) refutation of industry arguments—they don’t want the subsidy reduced—that higher RCRs would undermine FIs intermediation function and seriously damage the economy. But what is an appropriate RCR? Admati and friends say 20-30%.

Section III presents Engle and friends safe capital ratio (SCR). Brownlees and Engle (2012) estimate the “systemic” risk that the largest 100 US FIs contribute to the system. The systemic risk is the estimated capital shortfall for an institution in a crisis. As of 12/2014 (the most recent data) the ten riskiest institutions contributed 90% of the aggregate systemic risk. Acharya, Engle, and Richardson (2014) find a SCR that sets the institution’s systemic risk to zero. I calculate the difference the institution’s actual capital ratio (ACR) and SCR with the 2014 data. And the gap between the SCRs and the ACRs is surprisingly small. The three riskiest depository institutions and two riskiest broker dealers need to increase their capital to asset ratio by about 6%--from 9% to 15%. And the five riskiest insurance companies need a larger increase of 11% to reach a SCR of 17% from their low ACR of 6%. These increases are not that large and would eliminate 90% of the systemic risk according to Engle and friends’ estimates.

The Federal Reserve Board sets regulatory reserve requirements for depository institutions and Dodd- Frank gave the Financial Stability Oversight Council the authority to regulate any financial institution if they contributed to systemic risk. So the increased RCRs can be implemented without Congressional action.

A basic question is how long does an institution have to close the gap between their SCR and ACR and should the time be state dependent?

Section IV proposes a simple state dependent RCRR rule of thumb. In normal times the RCR equals the SCR; in a crisis—capital is buffer that gets run down so RCR equals the ACR. After a crisis one wants the least risky institutions to make loans to support the recovery and the riskiest institutions to retrench and build up their capital. The RCRR gives FIs with a smaller capital gap (SCR – ACR) than the expected capital

3 See https://www.fdic.gov/regulations/resources/director/regcapintfinalrule.pdf for a detailed description of Tier 1 capital and the various regulatory capital ratios.

3 gap for the average institution (less risky FIs) more time to adjust and FIs with a greater capital gap less time to adjust.

Section V gives the summary and conclusions.

Section II: Regulatory Capital Requirements

Basel III introduced a minimum “leverage ratio” that requires banks to have common equity that is 3% of assets4, and the US Federal Reserve said they would impose a minimum leverage ratio5 of 6% on eight systemically important banks. These are not onerous capital ratios. But what’s most unusual is that it’s a requirement. No institutions other than financial institutions have capital requirements. This section looks at why financial institutions have and need capital requirements.

Do Depository Institutions hold less Capital?

Figure II.1 shows actual capital ratios (ACRs)—common equity/assets == (market capitalization)/(book value of debt+market cap)--for nine well known US firms and the maximum and average depository institution’s ACR6 (see Appendix 2 for a full list of the thirty depository institutions).

Actual Capital Ratios December 2014 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2

Equity/Asset Ratio 0.1 0

Depository institutions’ capital ratios are low relative to other firms. The two bars on the far right summarize the depository institutions. The maximum for a depository institution—US BankCorp—is 19%

4 The traditional definition of the leverage ratio is assets/equity so Basel III “leverage ratio” is the reciprocal of the traditional definition. 5 See https://www.fdic.gov/regulations/resources/director/regcapintfinalrule.pdf for a detailed description of Tier 1 capital and the various regulatory capital ratios. 6 See Section III for more detail. ACR = E/A = Market Value of Equity/(book value debt + Market Value of Equity).

4 while the minimum for the other firms—AMD—is 36%. And the average ACR is for the depository institutions is 13% while the average is 65% for the other firms.7 And all depository institutions’ ACRs are clustered near the low mean. The standard deviation of ACRs for depository institutions is only 3%. In contrast, the standard deviation of the ACRs of the other nine institutions in Figure II.1 is over six times as large at 20%.

Why Do Depository Institutions hold less Capital?

The famous Modigliani-Miller theorem proves—given perfect markets—that it is the value of the firm that matters and the financing mix equity/debt is irrelevant—see Appendix 1. Increasing the debt/equity ratio increases the risk and the expected return to equity. It also increases the risk of debt and the default premium which makes it more expensive for firms to borrow. In equilibrium firms are indifferent to the financing mix. Of course actual markets don’t meet the assumptions of the MM theorem. But by eyeball econometrics the institutions—except for depository institutions—in Figure II.1 don’t violate MM theorem. ADM has 36% capital and Intel has 80%--they each manufacture computer chips. There is no pattern to the other institutions capital ratios either except for depository institutions.

The government debt guarantee for financial institutions breaks the natural market equilibrating mechanism by making depository institutions’ debt default free. With the guarantee depository institutions can increase the expected return to capital (and risk) without having to pay the cost of higher default premiums on their debt. And if things go badly the government absorbs the loss while if things go well the depository institution takes the upside gain.

The debt guarantee is a subsidy to financial institutions, see Appendix 1 for an analytic representation of the subsidy. It encourages depository institutions to hold excessive debt and risk. Figure II.2 shows the capital ratios for the twenty riskiest financial institutions8 one quarter before the financial meltdown in October 2008. Figure II.2

7 This is not the result of cherry picking the data. The exact numbers will change with time periods and comparison groups, but depository institutions have the lowest capital ratios. 8 This is from VLabs’ Systemic Risk calculations—see Section III.

These capital ratios are extremely low—the institutions rode the government guarantee for the maximum benefit. Fannie Mae had 1.3% capital and Freddie Mac had only 0.06%. The government took Freddie and Fannie over and honored their debt. Of the twenty institutions only two went bankrupt so that debtholders suffered a loss—infamous Lehman Brothers who held only 2% capital and plunged world financial markets into a panic, and Washington Mutual (3% capital) who succumbed to an orderly death when the FDIC took over. But the 18 others survived or at least their debtholders didn’t suffer. Bank of America—with considerable pressure from regulators—bought Countrywide and Merrill Lynch. Wells Fargo bought Wachovia. And PNC bought its rival National City Bank using Troubled Asset Relief Program (TARP)9 bailout funds. Of the remaining seven depository institutions all of them received TARP bailout funds. And, AIG, an insurance company that wrote credit default swaps on mortgage backed securities (a default guarantee) purchased by many depository institutions received a huge bailout from the Federal Reserve10.

Why do Governments Guarantee Financial Institution Debt?

The Great Depression and the Great Recession provide ample evidence that when the financial sector collapses the collapse of the real sector will follow. When a systemically important financial institution fails the damage extends far beyond its creditors and shareholders. The failure of Lehman Brothers, a medium size investment bank, froze overnight credit markets worldwide11. Governments and Central

9 The Troubled Asset Relief Program—a program hastily enacted in November of 2008 to limit the financial collapse by bailing out banks. 10 The AIG bailout was indirect support for the banks that held the mortgage backed securities. 11 Lehman—a medium sized investment bank—froze financial markets because of the opaque web of debt connections. When Lehman declared bankruptcy is was immediately clear who they owed and how much—these

Banks properly take measures to avoid the failure of institutions spreading to the rest of the financial market. After bank runs in the Great Depression led to the failure of many banks—small and large, some solvent some insolvent—the US enacted Federal Deposit Insurance—a debt guarantee. Since then, implicit debt guarantees are more common, the TARP bailout, Freddie and Fannie, and the coerced acquisitions of Bear Stearns, Merrill Lynch, and others.

Why Government Debt Guarantees justify Regulatory Capital Requirements

The debt guarantee provides a subsidy to the institution that encourages them to take on excessive debt and risk—see Figure II.2. The debt guarantee interferes with the normal market mechanism that says more debt risk implies a higher risk premium which gives firms a market incentive to limit debt. To offset the market failure introduced by the government guarantee of financial institution debt the government needs regulatory capital requirements that impose a lower limit to the capital(equity)/asset ratio.

Section III presents quantitative estimates of a safe capital ratio (SCR).

Financial Industry Arguments against higher Regulatory Capital Requirements

Debt guarantees are a subsidy to financial institutions and higher RCRs reduce the value of the subsidy. Of course the industry vigorously opposes any effort to increase RCRs. Admati and friends—Admati, DeMarzo, Hellwig, and Pfiederer (2011), and Admati and Hellwig (2013)--present the best analytic and logical arguments to refute the financial sector’s claims that higher RCR—higher equity—is expensive and will damage the economy.

Admati and friends have been moderately successful in selling their position to non-economists12. Senators Brown and Vittner introduced a bill in 2013 that would that would require very large banks to hold 15% capital to assets---very close to the safe capital ratio for the systemically riskiest three depository institutions and two broker dealers presented in Section III.13And Admati testified before the Senate Committee on Banking in 2014.

This subsection summarizes the industry’s claims and Admati and friends’ refutation, see their papers and book for convincing detail.

creditors would have to wait and get less than they loaned. What froze the market is the fear that if Lehman’s creditors didn’t get paid, then they would default and their creditors wouldn’t get paid so they would default, and so on. 12 Almost all economists accept that higher RCR are good, the only question is how much higher—as Stan Fischer asks. 13 The Brown-Vittner bill has not yet gotten out of committee. Congressional sentiment to impose stronger restrictions on banks doesn’t exist.

Industry Arguments and Admati and Friends’ Response

 Increased RCRs would force banks to hold in reserve funds that otherwise would be lent. o This represents an incredulous failure to understand basic accounting and economics— or cynical attempt to mislead the naïve (legislators?) who don’t understand basic accounting and economics. Firms fund assets with liabilities—debt and equity. A large portion of bank assets are loans to the public14. Increasing bank liabilities by adding equity gives the bank additional funds to lend, not less.  Increased RCRs would increase banks’ funding costs because equity requires a higher return than debt. o This is a more subtle argument. Equity and debt returns normally contain a risk premium. Higher debt/equity ratios make debt and equity riskier which implies higher risk premiums. The M-M theorem shows that with perfect markets firms are indifferent between debt and equity financing, see Appendix 1. The government debt guarantee for depository institutions transfers the debt risk to the government (public) and subsidizes debt financing for banks. So yes a higher RCR would make banks less risky—that’s the point—and reduce the risk premium on bank equity and the expected return. Furthermore it would reduce the value of the government subsidy from the debt guarantee which would decrease the value of bank equity. So the banking industry lobbies against higher RCRs.  Increased RCRs would increase banks’ funding costs because borrowing has favorable tax shields. o This is true. The US tax codes favor debt over equity financing because companies can deduct interest payments as an expense while dividend payments are not tax deductible. However, the tax code applies to all industries. The government guarantee of bank debt—not the tax code—drives depository institutions to use excessive debt financing, see Figure II.1

III. What is the Appropriate Regulatory Capital Ratio?

Section II and Appendix 1 show that government and/or central bank debt guarantees provide a subsidy to financial institutions that encourages them to hold excessive debt. And the data confirms that they hold much more debt relative to equity than other institutions. More debt means more risk. Appropriate RCRs are a way to balance the perverse incentive created by the debt guarantee. But as Stanley Fischer asked in his Martin Feldstein (2014) address what is the appropriate capital ratio? The Federal Reserve in 2014 declared that large depository institutions would have to meet a “leverage” ratio15 (a capital ratio) of 5% and systemically important depository institutions—eight at present—would have to meet 6%

14 Bank loans are liabilities to the public, but loans are assets to the bank. The public owes the value of the loan to the bank. 15 The “leverage” ratio in Fed regulations and Basel III a SCR in book value terms, ie, book value of common equity/(book value of equity + debt).

“leverage” ratio—by 2018. Adamiti and Helwig, the most vocal and successful academic advocates of higher RCRs, want 20%--30% for all banks.

Engle and friends (Broadlees and Engle 2012a), (Acharya, Engle, and Richardson 2012b) (Acharya, Engle, and Pierret 2014) suggest a safe capital ratio, SCR, for the large financial institutions (100 institutions with a market capitalization over $5billion)—depository, broker-dealers, insurance, and other (real estate)— that would offset their estimated contribution to systemic risk. Their suggested SCR is institution specific, depends on the current state of the economy, and is computed from publically available information. The information is online at V-Lab, http://vlab.stern.nyu.edu/analysis/RISK.USFIN-MR.MESSIM which is updated weekly.

Figure III.1 shows the actual capital ratios, as shown in Figure II.2, and AER’s safe capital ratio (explained below) for the twenty systemically riskiest US financial institutions as of July, 2008—the eve of the financial meltdown.

Figure III.1

The safe capital ratios—the second bar—are enormous relative to the actual capital ratios—the two largest SCR spikes, Washington Mutual and Wachovia, are at 60%. The VLab measure of systemic risk indicates these twenty institutions were extremely risky in July of 2008 (see Appendix 3 for details on

9 the 75 riskiest institutions). And subsequent events proved they were. All of the depository institutions—except Washington Mutual which the FDIC closed-got Troubled Asset Relief Program bailout funds—or were bought by another bank. Lehman Brothers when bankrupt and triggered the financial panic—and shortly after that AIG got a huge bailout from the Federal Reserve. As a consequence of the bailouts and the Great Recession financial oversight got stronger—Dodd, Frank in the US and Basel III internationally. Now depository institutions hold substantially more capital. But do they hold enough?

According VLab data as of December 2014 the top 10 risky institutions (5 of which are insurance companies) are responsible for 90% of the systemic risk. Increased capital requirements on 10 large institutions would make the system much safer. And the increases are not that large. The riskiest two broker dealers and three depository institutions would be required to increase capital by 6%--from 9% to 15%. The top 5 riskiest insurance companies would have to increase capital by 11%--from the low average of 6.5% to 17%. But, the 65 intuitions less risky than the top 10 on the VLab’s list on average hold capital that exceeds the SCR by 20%--see Appendix 2.??

III.a B&E’s Measure of Systemic Risk

B&E (2012a) propose and calculate a measure of the “systemic risk” that a financial institution contributes to the economy.16 The institution contributes to systemic risk if it cannot meet its debt obligations and its resolution—bankruptcy (think Lehman Brothers) or sale (think Bear Sterns)—spills over to affect other financial and non-financial institutions. In normal times banks that are not mega banks that experience an idiosyncratic loss can sell assets to regain their balance or they get bought by another institution. But in bad times when all institutions experience a market loss and they need to contract they cannot sell assets without severely depressing prices because there are few willing buyers and many sellers. Mega banks affect prices more in a fire sale since they have more to sell—hence the phrase “To Big to Fail”.

B&E’s quantitative measure of systemic risk, SRISK, depends on the firm’s size, ACR (equity/(equity + debt), the state of the economy, the firm’s idiosyncratic risk, and it’s correlation with the market (roughly it’s  ). SRISK is computed with current publicly available data—a great advantage in terms of transparency.

They define SRISK as,

SRISKi,1 t E t ( capital shortfall i | crisis ) (2.1) the expected capital shortfall for firm i given a crisis17.

16 B&E have an empirical paper. Acharya, et al (2010) have a theoretical paper. 17 B&E’s SRISK measure is similar in spirit to bank stress tests, see AEP (2014). Advantages of SRISK are that (1) it relies on publically available data, (2) it gets updated weekly and (3) it seems to be a more accurate measure than stress tests.

To quantify the shortfall B&E estimate a bivariate model of equity returns for firm i and the market return, see B&E section , and Achraya, Engle, and Richardson, section I. They calculate the long run (6 month) marginal expected shortfall (LRMES) in a crisis by dynamically simulating the model many times and averaging the returns of firm i when the market return falls by more than 40% over a six month horizon—a crisis.18 Given LRMES the calculation of the expected capital shortfall in a crisis is straightforward: the firm’s equity value is expected to decline by LRMESequityitit* and the book value19 of their debt is not expected to change much. Then,

SRISKEkdebtequityequity (()| crisis) i,1,,, tti ti ti t  (2.2) kdebtkLRMESequity*(1)*(1)*i,,, ti ti t

where k is a measure of a prudential capital buffer—Engle and friends choose 8%.

III.b Engle and Friends’ Proposed Safe Capital Ratio (SCR)

AER’s proposed safe capital ratio, SCR, sets the expected capital shortfall, to zero. Define the SCR as the capital ratio as,

equity SCRSRISK so that 0 (2.3) equitydebt

Manipulating equation (2.2) gives SCR as a simple function of the long run expected marginal shortfall, (eq 8 in Achraya, Engle, and Richardson)

k SCR  (2.4) 1 (1k ) LRMES

where k is the safe capital buffer (Engle and friends choose 8%). The SCR is easily computed from the data reported in VLab.

III.c Results

Table 2.1 in the Appendix 2 shows the VLab data for the 75 financial institutions SRISK as of 12/31/2014. VLab’s list of financial institutions includes depository institutions (banks), broker- dealers, insurance companies, and other (eg, real estate) with market capitalization over $5billion.

18 The broad market return fell by roughly 50% during the financial meltdown October 2008-March 2009. 19 The market value of the institution’s debt may change dramatically—but publically available numbers don’t reveal the market value of debt. B&E rely on the best public measure—the book value of debt and the market value of equity.

The Figure III.2 below shows the SCR and the actual capital ratio (ACR) for the first (10/28/2008) and presumably most urgent recipients of the troubled asset relief program (TARP)—the bad boys20. Probably not by coincidence these same eight institutions are the only US institutions on the (11/01/2014) Basel III list of globally systemic important banks.

Figure III.2

Acutal and Safe Capital Rations for TARP Bailout Banks 12/2014

0.18 0.16 0.14 0.12 0.1 0.08 0.06 0.04 0.02 0 JPMorgan Citigroup Bank of Morgan Goldman Bank of State Wells Chase & Inc America Stanley Sachs New York Street Fargo & Co Corp Group Mellon Corp Co Inc/The Corp/The

ACR SCR

The first three bad boys in 2008—JPMorgan-Chase, Citigroup, BofA—depository institutions, still have fairly low ACRs (Equity/Assets) and they are huge banks. They rank 1,2,3 on VLabs’ list of contributors to systemic risk—see Appendix 2, Table ??. The next two on the list of bailout recipients—Morgan-Stanley and Goldman-Sachs—listed as Broker-Dealers, rank 6,7 on VLab’s list of contributors to systemic risk.

Surprisingly the increases in capital to achieve the proposed SCR for this group of repeat offenders is not that large21. The three largest offenders—JPMorgan-Chase, Citigroup, and BofA—would have to increase their capital/asset ratio by about 6% to 16%. Morgan-Stanley and Goldman-Sachs would

20 See Table 2.?? Appendix 2 for details. 21 The increase in capital in 07/2008 to reach a SCR was 20%.

have to increase theirs by about 5% to 15%22. (This is surprising relative to 2008 when they would have needed to increase capital by 25-30% to reach the SCR, see figure III.1 and Appendix 3). And Wells Fargo’s ACR is greater the proposed SCR by almost 3%. In fact, most financial institutions meet or exceed the SCRs. The average increase in required capital for institutions 11-30 on VLab’s list is only 0.6%. The remaining institutions hold adequate capital. See Appendix 2, Table??.

The proposed SCRs to set systemic risk to zero, as measured in VLab, are not radical and should be politically feasible. The top 10 institutions on VLab’s list account for 90% of SRISK and the top 5 account for 70%. The Federal Reserve Board sets regulatory reserve requirements for depository institutions—so they don’t need Congressional action to implement increased reserve requirements. And Dodd-Frank gave the Financial Stability Oversight Council the authority to regulate any financial institution if they contributed to systemic risk. MetLife—America’s largest insurance company—and 4th on VLab’s list challenged the Financial Oversight Council’s authority to impose stricter oversight in court.

22 In the 2014 Federal Reserve stress tests Citigroup, JPMorgan Chase and Morgan Stanley all fell below 5 percent when applying a measure of capital known as the “leverage ratio.” But each remained above the minimum of 4 percent (NYTimes 03/05/15).

Section IV: A Proposal for a Regulatory Capital Ratio Rule (RCRR)

Section II and Appendix 1 showed that SCRs are needed to counter the incentive to take on excessive debt and risk created by a government debt guarantee for financial institutions. Section III showed that AER’s proposed SCR is not radical and should be politically feasible. This section implements AER’s SCR. My rule is basically a smoothed version of AER’s SCRs which I call a regulatory capital ratio rule.

A SCR serve two purposes:

1. SCRs make private financial institutions less risky and much less likely to impose private losses on the public. And as Admati and friends show, the economic cost is not high for the “banks”. And the benefit to society can be very large. 2. A higher capital/asset ratio provides the institution with a buffer to absorb losses without a government bailout.

The capital buffer is why a SCR rule needs smoothing to become a RCRR. Financial institutions should accumulate capital in good times—the SCR insures that they accumulate enough—and use the capital in bad times to weather the economic storm. A sufficient equity buffer assures the institution’s creditors—much like a government debt guarantee—that in a crisis the value of the institution’s debt is safe. So the “bank” can roll over debt as it expires.

The complicated and controversial component of a regulatory capital ratio rule is: after a period of stress how quickly should the institution be required to rebuild its capital?

A Simple Regulatory Capital Ratio Rule

It is important to recognize that a Regulatory Capital Rule rule based on Engle and friends work is (1) institution specific, (2) targets the systemically riskiest institutions (size matters—the failure of a small financial firm has smaller spillover effects) and (3) depends on the state of the economy.

Normal

When the state of the economy is good and has been for a while (defined more precisely below)— measured as the equity market return is positive—then, the regulatory capital requirement for next quarter (for institution i) ,

RCRSCRi,1, ti t  (1.1) equals the safe capital requirement calculated at the end of the current quarter.

Stress

When the state of the economy is bad—the equity market return is negative—then, the institution uses its capital buffer. So that,

R C Ritit A,1, C R (1.2) the regulatory capital ratio next quarter equals the current actual capital ratio. If the equity market return is negative for consecutive quarters, then the regulatory capital ratio next quarter again equals the actual capital ratio this quarter.

In the last 25 years consecutive quarters of negative returns on the S&P500 including distributions only occurred three times: (1) when the DotCom bubble burst in 2000 returns were negative for 4 consecutive quarters and the cumulative loss was 22%23, (2) in the recession of 2002 returns were negative for 2 quarters in a row and the cumulative market loss was 28%, and (3) in the Great Recession returns were negative for 6 consecutive quarters in 2007-08 and the cumulative market loss was 45%.

Adjustment Path to a Safe Capital Ratio

After a downturn there is a tension between a financial institution acquiring more assets (making loans) which enables the recovery and the need to rebuild its capital. The policy goal is for less risky institutions to make loans and riskier ones to retrench.

I present a simple rule for the time to rebuild capital that (1) depends on the cumulative equity market loss (CML) (2) the average institution’s safe capital ratio (ASCR) and (3) the institution’s actual capital ratio. It rewards safer institutions with more time to reach the safe capital ratio—so that they can lend more—and forces riskier institutions to reach the safe capital ratio more quickly—so they must contract.

Define the expected capital gap as,

ECGASCRCML **average  (1.3) the average institution’s safe capital ratio times the cumulative market loss times the average financial institution’s 24  . So for example, if the cumulative market decline were 10% and average institution’s safe capital ratio and actual capital ratio was 20%, then one might expect it to lose 2% of its actual capital ratio. But since financial institutions’ average  is 1.09—they are slightly risker than the market—the average institution would be expected to lose slightly more, 2.18%.

23 The DotCom bubble hit smaller high tech firms and affected the S&P much less. 24 See Appendix 2. Table ??

Table IV.1 shows the ECG for the average financial institution with a SCR of 13% and a beta of 1.0925for CMLs from 0.10 to 0.40.

Table IV.1: Expected Capital Gap (for the average institution) for a Cumulative Market Loss

CML 0.10 0.20 0.30 0.40 ECG 0.0142 0.0283 0.0425 0.0567

An Adjustment Rule

My rule rewards institutions whose actual capital loss is less than the average expected capital loss— gives less risky institution’s more time to attain their safe capital ratio—and penalizes institutions whose actual loss is greater than the average expected capital loss. The adjustment rule is,

T abECGACG*exp(()) (1.4) CML*100 i where T is the time in quarters to reach the SCR. a and b are parameters. a is a scale parameter that sets T relative to the CML. So for example, if a=0.5, and the market fell by 10% and institution i’s gap relative to the average expected gap is zero, ECG-ACG = 026, then the institution has 5 quarters, or 1 1/4 years— same as the average institution—to reach its SCR. b sets the curvature of the reward/penalty ratio for institutions that have a smaller or larger than expected capital gap.

Figure IV.1 illustrates the rule, equation (1.4), for a=0.5, b = 25. Where the horizontal line at 0.5 crosses the curves, eg CML = 0.40 shows the average institution’s expected capital gap—0.0567—on the x axis. The vertical axis shows the normalized time to allowed reach the SCR. So an institution with a 5.67% capital gap after a 40% decline in the equity market—which is only slightly less than the CML in the Great Recession—has 5 yrs (= .5*40/4) to attain the SCR. Riskier institutions—to the right on the graph have less time to reach their SCR, eg, the riskiest with institutions (with a Beta = 1.75*the average Beta) whose capital/asset ratio falls by 10% have less than 2 years to attain a SCR and the safest institutions to the left on the graph with a Beta = 0.25*average Beta whose capital/asset ratio falls by only 1 ½% would have 14 years to reach their SCR27. The goal is to constrain risky institutions forcing them to build up capital and pay down their debt, while not constraining less risky institutions so that they make loans to support the recovery.

25 These are the averages of 75 financial institutions at the end of 2014 listed in VLab—see Appendix 2, Table ??

26 The exponential term in equation 4.4 equals one. 27 The lowest  of the 75 financial institutions listed in VLab is 0.8. An institution with a of 0.75 capital/asset ratio would fall by 4 ¼% and it would have 7 years to reach its SCR.

Figure 4.1

Time to reach a Safe Capital Ratio 1.5

CML = 0.40 1

CML = 0.30

CML = 0.20

CML = 0.10 0.5

Time to adjust relative to Cumulative Market Loss

0 0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1 Actual Capital Gap

Conclusions

To be written

Appendix 1: Analytical basis for Financial Institution Regulatory Capital Requirements

This appendix is the foundation of the intuitive discussion in Section II. It proves the Modigliani-Miller theorem and shows that the government debt guarantee for financial institutions is a subsidy. And it shows that the value of the subsidy is increasing in the debt to equity ratio.

Modigliani-Miller Theorem

The M-M Theorem shows that it is the value of the firm, V, that matters. The financing mix--E ,equity, and D, debt—is irrelevant.

Modigliani and Miller published their Theorem and ingenious proof in 1958. The proof is as complicated as it is ingenious. Arrow and Debreu published their path breaking work on the existence and welfare properties of a competitive equilibrium in 1954. But financial economists and others did not realize the power, beauty, and simplicity of the A-D setup until years later. This Appendix proves M-M using A-D the contingent claims setup. I present a simplified two period version of the proof in Merton (1992) and Ljungqvist and Sargent (2004).

Assumptions: standard assumption for the existence of a competitive equilibrium.

Define: p(s) == the Arrow-Debreu price of a contingent commodity in state s next period. The states, s, are stochastic and defined by a probability distribution. The price, p(s), incorporates time discounting and uncertainty.

x(s) == the net asset value of the firm next period in state s

n == the promised payoff to debtholders in all states. If the firm cannot meet the promised debt obligation, then debtholders get the firm, worth x(s), and equity holders get nothing.

Then,

V  p( s ) x ( s ) the current value of the firm E p( s ) max(x(s) n,0) the current equity value (market cap) of the firm D  p( s ) min( n , x ( s )) the current value of debt of the firm

The Modigliani-Miller Theorem VED  p( s ) x ( s )  p(s) max(( x ( s )  n ),0)   p(s) min( n , x ( s )) s 

The financing mix, D/E, is irrelevant. The proof is so deceptively simple it masks generality of the result.

Why Debt Guarantees for Financial Institutions Require regulatory Capital Ratios

Governments guarantee financial institutions debt because the failure of a significant financial institution spreads well beyond losses to the firm’s equity and debt holders—a negative externality. But the debt guarantee is a subsidy to the financial institution, and the subsidy is increasing in value with the debt to equity ratio. So institutions with a guarantee have an incentive to hold excessive debt.

The guarantee makes the institution’s debt default free. The value of the default free debt is,

Ddf  n p() s And as Merton (1977) shows the value of the firm’s risky debt with a government guarantee equals the value firm’s risky debt plus a put option with a strike price of the firm’s promised debt payment, n,

DDdf  x snPut( ( ), x )( sn ( ), )

 ps( ) min(x(s),n)max(nx(s),0) 

The guarantee violates the M-M perfect markets assumption. The equity value plus the value of the guaranteed debt of the financial institution is greater than the value of the firm,

VEDEDPut x sn (( ),)

The debt guarantee is a subsidy to the institution. Merton proposed that the fairly priced deposit insurance premium equal the value of the put option, i.e., the value of the subsidy.

The value of the Put, Put( n ,( x ))( sp )max(nx(s),0)s Is increasing in the promised debt payment, n, (the institution’s debt). An appropriate RCR reduces debt and the risk—which is the point. It also reduces the value of the subsidy. A safe capital ratio, SCR, (see Section III) can make the likelihood of default so small that the value of the put option, the subsidy, is essentially zero.

Appendix 2: VLab Data 12/2014

Table 2.1

SRISK ($ Institution SRISK% RNK m) LRMES Beta Cor Vol Lvg SCR ACR

JPMorgan Chase & Co 19.58 1 81418 52.5 1.22 0.77 19.5 10.81 0.154739 0.092507 Citigroup Inc 15.28 2 63566 53.53 1.34 0.75 22.1 11.19 0.157628 0.089366 Bank of America Corp 13.26 3 55162 44.75 1.05 0.71 18.4 11.02 0.135985 0.090744 MetLife Inc 11.65 4 48460 67.24 1.7 0.79 26.8 14.62 0.209758 0.068399 Prudential Financial Inc 10.25 5 42627 60.22 1.36 0.73 23.1 18.44 0.179382 0.05423 Morgan Stanley 6.86 6 28542 55.94 1.33 0.72 22.8 10.76 0.164829 0.092937 Goldman Sachs Group Inc/The 4.48 7 18643 43.52 1.27 0.77 20.5 10.26 0.133419 0.097466 Lincoln National Corp 3.11 8 12937 62.5 1.51 0.78 24 16.11 0.188235 0.062073 Capital One Financial Corp 2.97 9 12351 80.71 1.13 0.67 21 6.58 0.310718 0.151976 Hartford Financial Services Group Inc/The 2.52 10 10499 54.49 0.96 0.66 17.9 13.53 0.16042 0.07391 Principal Financial Group Inc 2.34 11 9747 51.96 1.61 0.74 26.7 14.51 0.153266 0.068918 Genworth Financial Inc 1.58 12 6581 77.08 0.73 0.17 52.7 23.12 0.275043 0.043253 Bank of New York Mellon Corp/The 1.48 13 6172 48.46 0.98 0.68 17.7 8.62 0.144361 0.116009 Unum Group 0.76 14 3178 87.14 1.33 0.61 26.8 7 0.403405 0.142857 State Street Corp 0.56 15 2316 40.45 1.29 0.68 23.3 8.73 0.127417 0.114548 Fifth Third Bancorp 0.51 16 2104 52.1 1.09 0.67 20 8.08 0.153645 0.123762 Zions Bancorporation 0.4 17 1677 59.17 1.13 0.63 22.1 9.32 0.175579 0.107296 Regions Financial Corp 0.39 18 1609 50.97 1.24 0.69 22.3 8.02 0.150638 0.124688 Northern Trust Corp 0.36 19 1476 53.9 1.1 0.71 19.3 7.46 0.158692 0.134048 BB&T Corp 0.35 20 1435 55.04 1.04 0.71 18.1 6.81 0.162064 0.146843 Huntington Bancshares Inc/OH 0.28 21 1182 56.09 1.12 0.67 20.6 7.77 0.165299 0.1287 E*TRADE Financial Corp 0.2 22 829 62.58 1.6 0.65 30.3 6.78 0.188562 0.147493 SunTrust Banks Inc 0.18 23 761 38.3 1.07 0.72 18.3 8.53 0.123525 0.117233 Comerica Inc 0.16 24 662 45.06 1.27 0.63 25.1 8.3 0.136647 0.120482 KeyCorp 0.12 25 508 47.33 1.13 0.7 20.1 7.59 0.141702 0.131752 Ameriprise Financial Inc 0.11 26 439 52.84 1.63 0.79 25.5 6.65 0.155681 0.150376 Synovus Financial Corp 0.07 27 296 55.14 1.07 0.67 19.8 7.16 0.162367 0.139665 People's United Financial Inc 0.06 28 254 49.88 0.79 0.59 16.6 7.44 0.147846 0.134409

Assurant Inc 0.06 29 233 59.44 1.02 0.66 19.1 6.27 0.176541 0.15949 MBIA Inc 0.05 30 216 54.67 1.02 0.48 26.3 7.68 0.160954 0.130208 Commerce Bancshares Inc/MO 0 31 -396 47.32 0.81 0.64 15.8 5.88 0.141679 0.170068 Hudson City Bancorp Inc 0 32 -442 38.46 1.06 0.65 20.3 7.04 0.123807 0.142045 New York Community Bancorp Inc 0 33 -443 40.53 0.93 0.67 17.2 7.06 0.127566 0.141643 M&T Bank Corp 0 34 -943 49.34 1.07 0.71 18.7 6.12 0.146501 0.163399 CIT Group Inc 0 35 -961 50.83 1.16 0.7 20.3 5.28 0.150273 0.189394 Janus Capital Group Inc 0 36 -1031 59.25 1.37 0.59 28.6 1.39 0.175863 0.719424 Aflac Inc 0 37 -1327 60.2 0.87 0.64 16.7 4.97 0.179308 0.201207 American Capital Ltd 0 38 -1380 58.09 0.89 0.52 21.3 1.44 0.171832 0.694444 Health Net Inc/CA 0 39 -1390 57.17 0.98 0.49 24.7 1.76 0.168764 0.568182 SLM Corp 0 40 -1393 44.92 0.81 0.45 22.2 3.3 0.136348 0.30303 Eaton Vance Corp 0 41 -1664 60.74 1.02 0.49 25.8 1.22 0.181327 0.819672 Torchmark Corp 0 42 -1714 54.12 1.03 0.71 18 3.2 0.159332 0.3125 CBRE Group Inc 0 43 -1746 79.25 1.16 0.6 23.8 1.47 0.295312 0.680272 CNA Financial Corp 0 44 -1905 44.65 0.91 0.66 17 5.09 0.135773 0.196464 WR Berkley Corp 0 45 -1908 44.93 0.79 0.59 16.7 3.67 0.136369 0.27248 Legg Mason Inc 0 46 -2167 58.42 1.61 0.69 28.6 1.33 0.17296 0.75188 SEI Investments Co 0 47 -2364 61.31 0.94 0.63 18.6 1.04 0.183508 0.961538 BlackRock Inc 0 48 -2557 66.49 1.48 0.8 22.9 4.31 0.206031 0.232019 Cincinnati Financial Corp 0 49 -2912 50.23 0.82 0.67 15 2.43 0.148731 0.411523 Charles Schwab Corp/The 0 50 -3773 59.6 1.66 0.73 28.1 4.45 0.177117 0.224719 Western Union Co/The 0 51 -3855 47.19 1.35 0.59 28.4 1.93 0.14138 0.518135 PNC Financial Services Group Inc/The 0 52 -4654 36.94 1.09 0.73 18.3 7.04 0.121184 0.142045 FNF Group 0 53 -4876 39.49 0.62 0.32 24.4 1.59 0.125649 0.628931 Cigna Corp 0 54 -5795 62.27 0.88 0.53 20.4 2.65 0.187303 0.377358 Aon PLC 0 55 -6185 68.24 0.74 0.52 17.7 1.79 0.214943 0.558659 H&R Block Inc 0 56 -6220 25.31 0.99 0.44 27.6 1.2 0.104282 0.833333 TD Ameritrade Holding Corp 0 57 -7044 52.12 1.61 0.72 27.9 1.98 0.1537 0.505051 Progressive Corp/The 0 58 -7177 41.06 0.86 0.63 16.8 2.12 0.128566 0.471698 American International Group Inc 0 59 -7294 45.68 0.98 0.72 16.7 6.08 0.137992 0.164474

Allstate Corp/The 0 60 -7403 49.54 0.69 0.6 14.3 3.66 0.146996 0.273224 Intercontinental Exchange Inc 0 61 -8027 45.46 0.86 0.51 20.7 3.21 0.137512 0.311526 T Rowe Price Group Inc 0 62 -8710 57.28 1.17 0.78 18.6 1.02 0.169125 0.980392 Humana Inc 0 63 -8914 50.31 0.92 0.39 28.8 1.66 0.148935 0.60241 Chubb Corp/The 0 64 -9933 43.07 0.59 0.58 12.7 2.46 0.132504 0.406504 CME Group Inc/IL 0 65 -10806 48.31 0.83 0.51 20.2 2.42 0.144002 0.413223 Eaton Corp PLC 0 66 -11376 56.97 1.27 0.66 23.7 1.54 0.168111 0.649351 US Bancorp/MN 0 67 -11589 46.7 0.97 0.78 15.4 5.33 0.140262 0.187617 Franklin Resources Inc 0 68 -13081 57.78 1.49 0.75 24.6 1.11 0.170785 0.900901 Travelers Cos Inc/The 0 69 -13281 39.21 0.62 0.6 12.9 3.26 0.125143 0.306748 Aetna Inc 0 70 -13594 42.08 1.08 0.58 23.2 2.22 0.130535 0.45045 Marsh & McLennan Cos Inc 0 71 -18834 31.17 0.87 0.63 16.9 1.31 0.112165 0.763359 Wells Fargo & Co 0 72 -26109 45.55 0.93 0.77 15 6.11 0.137708 0.163666 American Express Co 0 73 -27289 57.12 1.08 0.69 19.4 2.39 0.1686 0.41841 UnitedHealth Group Inc 0 74 -37418 53.35 0.99 0.55 22.2 1.54 0.157115 0.649351 Berkshire Hathaway Inc 0 75 -86740 68 0.89 0.71 15.4 1.76 0.213675 0.568182

Table 2.2

Broker Dealers SRISK ($ Institution SRISK% RNK m) LRMES Beta Cor Vol Lvg SCR CCR Morgan Stanley 6.86 6 28542 55.94 1.33 0.72 22.8 10.76 0.164829 0.092937 Goldman Sachs Group Inc/The 4.48 7 18643 43.52 1.27 0.77 20.5 10.26 0.133419 0.097466 E*TRADE Financial Corp 0.2 22 829 62.58 1.6 0.65 30.3 6.78 0.188562 0.147493 Charles Schwab Corp/The 0 50 -3773 59.6 1.66 0.73 28.1 4.45 0.177117 0.224719 T Rowe Price Group Inc 0 62 -8710 57.28 1.17 0.78 18.6 1.02 0.169125 0.980392

Depositories SRISK ($ Institution SRISK% RNK m) LRMES Beta Cor Vol Lvg SCR CCR JPMorgan Chase & Co 19.58 1 81418 52.5 1.22 0.77 19.5 10.81 0.154739 0.092507 Citigroup Inc 15.28 2 63566 53.53 1.34 0.75 22.1 11.19 0.157628 0.089366 Bank of America Corp 13.26 3 55162 44.75 1.05 0.71 18.4 11.02 0.135985 0.090744 Bank of New York Mellon Corp/The 1.48 13 6172 48.46 0.98 0.68 17.7 8.62 0.144361 0.116009 State Street Corp 0.56 15 2316 40.45 1.29 0.68 23.3 8.73 0.127417 0.114548 Zions Bancorporation 0.4 17 1677 59.17 1.13 0.63 22.1 9.32 0.175579 0.107296 Regions Financial Corp 0.39 18 1609 50.97 1.24 0.69 22.3 8.02 0.150638 0.124688 Northern Trust Corp 0.36 19 1476 53.9 1.1 0.71 19.3 7.46 0.158692 0.134048 BB&T Corp 0.35 20 1435 55.04 1.04 0.71 18.1 6.81 0.162064 0.146843 Huntington Bancshares Inc/OH 0.28 21 1182 56.09 1.12 0.67 20.6 7.77 0.165299 0.1287 SunTrust Banks Inc 0.18 23 761 38.3 1.07 0.72 18.3 8.53 0.123525 0.117233 Comerica Inc 0.16 24 662 45.06 1.27 0.63 25.1 8.3 0.136647 0.120482 KeyCorp 0.12 25 508 47.33 1.13 0.7 20.1 7.59 0.141702 0.131752

Synovus Financial Corp 0.07 27 296 55.14 1.07 0.67 19.8 7.16 0.162367 0.139665 People's United Financial Inc 0.06 28 254 49.88 0.79 0.59 16.6 7.44 0.147846 0.134409 Commerce Bancshares Inc/MO 0 31 -396 47.32 0.81 0.64 15.8 5.88 0.141679 0.170068 Hudson City Bancorp Inc 0 32 -442 38.46 1.06 0.65 20.3 7.04 0.123807 0.142045 New York Community Bancorp Inc 0 33 -443 40.53 0.93 0.67 17.2 7.06 0.127566 0.141643 M&T Bank Corp 0 34 -943 49.34 1.07 0.71 18.7 6.12 0.146501 0.163399 PNC Financial Services Group Inc/The 0 52 -4654 36.94 1.09 0.73 18.3 7.04 0.121184 0.142045 US Bancorp/MN 0 67 -11589 46.7 0.97 0.78 15.4 5.33 0.140262 0.187617 Wells Fargo & Co 0 72 -26109 45.55 0.93 0.77 15 6.11 0.137708 0.163666

Insurance SRISK ($ Institution SRISK% RNK m) LRMES Beta Cor Vol Lvg SCR CCR MetLife Inc 11.65 4 48460 67.24 1.7 0.79 26.8 14.62 0.209758 0.068399 Prudential Financial Inc 10.25 5 42627 60.22 1.36 0.73 23.1 18.44 0.179382 0.05423 Lincoln National Corp 3.11 8 12937 62.5 1.51 0.78 24 16.11 0.188235 0.062073 Hartford Financial Services Group Inc/The 2.52 10 10499 54.49 0.96 0.66 17.9 13.53 0.16042 0.07391 Principal Financial Group Inc 2.34 11 9747 51.96 1.61 0.74 26.7 14.51 0.153266 0.068918 Genworth Financial Inc 1.58 12 6581 77.08 0.73 0.17 52.7 23.12 0.275043 0.043253 Unum Group 0.76 14 3178 87.14 1.33 0.61 26.8 7 0.403405 0.142857 Assurant Inc 0.06 29 233 59.44 1.02 0.66 19.1 6.27 0.176541 0.15949 MBIA Inc 0.05 30 216 54.67 1.02 0.48 26.3 7.68 0.160954 0.130208 Aflac Inc 0 37 -1327 60.2 0.87 0.64 16.7 4.97 0.179308 0.201207

Health Net Inc/CA 0 39 -1390 57.17 0.98 0.49 24.7 1.76 0.168764 0.568182 Torchmark Corp 0 42 -1714 54.12 1.03 0.71 18 3.2 0.159332 0.3125 CNA Financial Corp 0 44 -1905 44.65 0.91 0.66 17 5.09 0.135773 0.196464 Cincinnati Financial Corp 0 49 -2912 50.23 0.82 0.67 15 2.43 0.148731 0.411523 FNF Group 0 53 -4876 39.49 0.62 0.32 24.4 1.59 0.125649 0.628931 Cigna Corp 0 54 -5795 62.27 0.88 0.53 20.4 2.65 0.187303 0.377358 Aon PLC 0 55 -6185 68.24 0.74 0.52 17.7 1.79 0.214943 0.558659 Progressive Corp/The 0 58 -7177 41.06 0.86 0.63 16.8 2.12 0.128566 0.471698 American International Group Inc 0 59 -7294 45.68 0.98 0.72 16.7 6.08 0.137992 0.164474 Allstate Corp/The 0 60 -7403 49.54 0.69 0.6 14.3 3.66 0.146996 0.273224 Humana Inc 0 63 -8914 50.31 0.92 0.39 28.8 1.66 0.148935 0.60241 Chubb Corp/The 0 64 -9933 43.07 0.59 0.58 12.7 2.46 0.132504 0.406504 Travelers Cos Inc/The 0 69 -13281 39.21 0.62 0.6 12.9 3.26 0.125143 0.306748 Aetna Inc 0 70 -13594 42.08 1.08 0.58 23.2 2.22 0.130535 0.45045 Marsh & McLennan Cos Inc 0 71 -18834 31.17 0.87 0.63 16.9 1.31 0.112165 0.763359 UnitedHealth Group Inc 0 74 -37418 53.35 0.99 0.55 22.2 1.54 0.157115 0.649351 Berkshire Hathaway Inc 0 75 -86740 68 0.89 0.71 15.4 1.76 0.213675 0.568182

Appendix 3: VLab Data 07/2008

SRISK ($

Institution SRISK% LRMES Beta Cor Vol Lvg

RNK m) ACR SCR

Citigroup Inc 12.78 1 141,201 83 2.95 0.78 82.9 20.3 0.049261 0.338409

JPMorgan 9.91 2 109,567 83 2.3 0.72 69.3 12.77

Chase & Co 0.078309 0.338409

Bank of 8.93 3 98,726 81 3.21 0.77 91 11.61

America Corp 0.086133 0.313972

Morgan Stanley 6.45 4 71,280 79 2.48 0.78 68.9 23.76 0.042088 0.292826

Merrill Lynch 6.33 5 69,968 88 3.95 0.8 109.2 23.62 0.042337 0.420168

Freddie Mac 6.18 6 68,354 81 5.43 0.55 216.8 164.89 0.006065 0.313972

Fannie Mae 6.03 7 66,627 91 5.46 0.58 207.1 75.76 0.0132 0.4914

American International 5.86 8 64,817 81.16 3.2 0.68 103.3 14.85

Group Inc

0.06734 0.315796

Wachovia Bank 5.13 9 56,706 94 4.94 0.67 161.7 20.91 0.047824 0.591716

Goldman Sachs 4.81 10 53,166 55 1.66 0.78 46.3 15.34

Group Inc/The 0.065189 0.161943 Lehman 4.33 11 47,834 89 5.2 0.7 163.4 51.92 Brothers 0.01926 0.441501

MetLife Inc 2.72 12 30,112 65 1.31 0.75 38.3 15.46 0.064683 0.199005

Prudential 2.05 13 22,687 51 1.65 0.72 49.8 16.07

Financial Inc 0.062228 0.150716

Washington 1.99 14 21,960 95 4.46 0.45 218.3 31.78

Mutual 0.031466 0.634921

Hartford Financial 1.82 15 20,090 70 1.81 0.71 55.2 17.6 Services Group

Inc/The 0.056818 0.224719

Wells Fargo & 1.81 16 20,056 73 2.01 0.68 64.4 6.61

Co 0.151286 0.243605

National City 0.94 17 10,359 85 1.76 0.45 85.2 38.73

Corporation 0.02582 0.366972 SunTrust Banks 0.93 18 10,321 81.84 2.97 0.64 103 11.98 Inc 0.083472 0.323792

Lincoln National 0.93 19 10,261 68 1.8 0.8 49.4 15.05

Corp 0.066445 0.213675

SLM Corp 0.78 20 8,589 45 1.93 0.51 83.9 20.73 0.048239 0.136519

BB&T Corp 0.73 21 8,061 87 2.83 0.69 86.1 9.07 0.110254 0.400802

Regions 0.73 22 8,039 68 3.77 0.65 141.8 19.94

Financial Corp 0.05015 0.213675

US Bancorp/MN 0.69 23 7,605 78.86 2.4 0.73 72.2 5.21 0.191939 0.291452

Capital One 0.64 24 7,057 79 2.66 0.66 88.3 9.02

Financial Corp 0.110865 0.292826

Principal Financial Group 0.62 25 6,834 53 1.81 0.76 51.2 14.17

Inc 0.070572 0.156128

Keycorp 0.59 26 6,515 81 2.37 0.54 96.4 18.79 0.05322 0.313972

Fifth Third 0.55 27 6,116 70.07 2.41 0.53 99 13.92

Bancorp 0.071839 0.225126

Genworth 0.54 28 5,987 66 1.55 0.67 50.8 15.74

Financial Inc 0.063532 0.203666 Marshall & 0.38 29 4,221 89 2.72 0.68 90.1 15.66 Ilsley 0.063857 0.441501

Sovereign Bank 0.36 30 3,982 71 2.9 0.59 109.5 12.22 0.081833 0.230681

Ameriprise 0.35 31 3,847 55 1.32 0.7 41.2 11.27

Financial Inc 0.088731 0.161943

E*TRADE 0.35 32 3,814 92 3.41 0.53 140.4 31.32

Financial Corp 0.031928 0.520833

Zions 0.34 33 3,802 95 3.59 0.59 134.4 16.68

Bancorporation 0.059952 0.634921

Comerica Inc 0.34 34 3,800 73 2.84 0.63 100.5 15.1 0.066225 0.243605

Huntington Bancshares 0.34 35 3,703 91 3.39 0.46 171.1 20.04

Inc/OH 0.0499 0.4914

MBIA Inc 0.29 36 3,250 96 3.56 0.5 155.8 26.52 0.037707 0.684932

M&T Bank Corp 0.27 37 3,037 76 1.97 0.6 71.4 8.66 0.115473 0.265957

American 0.22 38 2,482 81 2.19 0.72 67.4 3.91

Express Co 0.255754 0.313972

PNC Financial Services Group 0.19 39 2,098 65 2.02 0.62 70.8 6.09

Inc/The 0.164204 0.199005

Synovus 0.18 40 1,942 82 2.96 0.59 112.1 10.8

Financial Corp 0.092593 0.325733 AMBAC 0.14 41 1,602 89 4.02 0.45 196 29.96 Financial 0.033378 0.441501

UnionBanCal 0.14 42 1,538 57 1.8 0.64 60.8 8.54 0.117096 0.168209

UNUM Group 0.12 43 1,296 71 1.25 0.66 41.4 6.27 0.15949 0.230681

CNA Financial 0.11 44 1,191 63 1.29 0.57 50.2 7.33

Corp 0.136426 0.190295

Bank Of New York Mellon 0.03 45 337 64 1.79 0.66 58.6 5.24

Corp/The

0.19084 0.194553

Commerce Bancshares 0.02 46 261 66.33 1.5 0.66 49.2 5.91

Inc/MO 0.169205 0.205252

New York Community 0.01 47 147 62 1.58 0.5 70.4 5.69

Bancorp Inc

0.175747 0.18622

American 0 48 -218 84 2.32 0.63 81.9 2.18

Capital Ltd 0.458716 0.352113

CBRE Group Inc 0 49 -219 76 4.51 0.49 197.3 2.8 0.357143 0.265957

Northern Trust 0 50 -453 62 1.59 0.71 48.8 5.04

Corp 0.198413 0.18622

Cincinnati 0 51 -606 66 1.6 0.68 51.7 3.24

Financial Corp 0.308642 0.203666

People's United 0 52 -628 66 1.37 0.62 49.4 3.58

Financial Inc 0.27933 0.203666

WR Berkley 0 53 -659 53 0.89 0.57 35.4 4.33

Corp 0.230947 0.156128

FNF Group 0 54 -1,132 47 1.66 0.5 71.5 2.37 0.421941 0.140944

SEI Investments 0 55 -1,230 69 1.51 0.76 44.9 1.08

Co 0.925926 0.219058

Health Net 0 56 -1,239 46 0.5 0.21 52.2 2.05

Inc/CA 0.487805 0.138696

Cigna Corp 0 57 -1,275 56 0.62 0.4 33.8 4.53 0.220751 0.165017

Torchmark Corp 0 58 -1,313 53 1.22 0.74 36.6 3.26 0.306748 0.156128

State Street 0 59 -1,356 58.03 1.7 0.61 59.8 5.28

Corp 0.189394 0.171628

Coventry Health 0 60 -1,493 62.69 0.45 0.19 55.5 1.73

Care 0.578035 0.189013

Humana Inc 0 61 -1,762 64 0.48 0.25 42.6 2.18 0.458716 0.194553

Eaton Vance 0 62 -1,765 54 2.22 0.77 62.4 1.16

Corp 0.862069 0.158983

Hudson City 0 63 -1,942 37 1.58 0.59 58.8 5.69

Bancorp Inc 0.175747 0.121286

Legg Mason Inc 0 64 -1,951 53 2.86 0.68 91.7 2.12 0.471698 0.156128

Janus Capital 0 65 -1,957 53 1.49 0.54 60.3 1.36

Group Inc 0.735294 0.156128

Allstate 0 66 -2,157 46 0.8 0.67 26.1 6.15

Corp/The 0.162602 0.138696

T Rowe Price 0 67 -2,533 82 2.19 0.8 59.6 1.03

Group Inc 0.970874 0.325733

NYMEX 0 68 -2,642 62 1.09 0.54 44.2 1.12 0.892857 0.18622

Intercontinental 0 69 -3,011 52 1.52 0.59 56.1 1.18

Exchange Inc 0.847458 0.153374

Assurant Inc 0 70 -3,079 26.04 0.55 0.44 27.9 4.09 0.244499 0.105203

Safeco 0 71 -3,500 23 0.42 0.31 30 2.5 0.4 0.101471

Travelers Cos 0 72 -3,535 56 1.25 0.69 39.6 4.36

Inc/The 0.229358 0.165017

Aon PLC 0 73 -3,738 56 1.11 0.62 39.7 2.39 0.41841 0.165017

TD Ameritrade 0 74 -3,966 51 1.73 0.71 53.1 2.44

Holding Corp

0.409836 0.150716

Charles Schwab 0 75 -4,168 68 1.8 0.74 53.3 2.69

Corp/The 0.371747 0.213675

H&R Block Inc 0 76 -4,284 37 0.75 0.46 35.9 1.51 0.662252 0.121286

Eaton Corp PLC 0 77 -4,448 51 1.24 0.68 39.8 1.9 0.526316 0.150716

BlackRock Inc 0 78 -4,666 77 2.14 0.7 66.5 1.37 0.729927 0.274348

Progressive 0 79 -4,911 52 0.75 0.47 35.4 2.03

Corp/The 0.492611 0.153374

NYSE Euronext 0 80 -5,160 50 1.64 0.75 62.7 1.6 0.625 0.148148

Chubb 0 81 -6,192 43 0.94 0.61 33.3 3.15

Corp/The 0.31746 0.132363

Franklin 0 82 -6,830 68 1.75 0.78 49.4 1.09

Resources Inc 0.917431 0.213675

Marsh & McLennan Cos 0 83 -6,867 43 1.07 0.59 39.6 1.62

Inc 0.617284 0.132363

Aflac Inc 0 84 -7,390 49 1.58 0.56 61.3 3.37 0.296736 0.145666

CME Group 0 85 -10,599 39 0.9 0.53 37.5 1.27

Inc/IL 0.787402 0.124766

Aetna Inc 0 86 -10,670 27 0.6 0.39 34.1 2.5 0.4 0.10644

Western Union 0 87 -13,821 24 0.7 0.48 32 1.29

Co/The 0.775194 0.102669

UnitedHealth 0 88 -18,168 34 0.69 0.33 46 2.01

Group Inc 0.497512 0.116414

Berkshire 0 89 -27,670 19 0.35 0.33 23.6 3.89

Hathaway Inc 0.257069 0.096946