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1 a Regulatory Capital Ratio Rule for Financial Institutions Roger Craine

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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 1 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.
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