Could more bank capital cause another bank crisis? So long as it’s (still) the wrong kind?
It’s a point picked up with some aplomb by Paul Marson, of Lombard Odier Private Banking. In fact, Marson reckons regulators’ refusal to distinguish between different types of capital will inevitably lead to another crisis. Think of the European Union’s idea of imposing a bank levy, the proceeds of which will be used to set-up a bail-out fund to — you guessed it — provide more monies for troubled banks.
Here’s what Marson says:
Once again, policymakers are demonstrating a fundamental inability to read balance sheets and to understand the role of bank capital: the charts [below] show US and Eurozone banks holding approximately USD 11 trn and USD 33 trn (USD 3.5 trn and USD 16 trn excluding deposits). The role of capital is, fundamentally, to absorb losses and, on this scale, banks have an enormous capacity to absorb losses before depositors are even remotely threatened . . .
. . . the great tragedy of the 2008/9 banking debacle was, despite the presence of more than sufficient capital, that the taxpayer was placed involuntarily into the capital structure, between bondholders and equity holders, to shield the bondholders from losses that they should have suffered. As it was, taxpayers absorbed all losses and bond holders were made good: in effect, the debt component of bank capital has been rendered entirely risk free! With USD 14 trn in Eurozone bank debt free from all potential losses, depositors fully protected, the “capital at risk” component of the capital base is a trivial USD 2 trn. The bank levy is a misguided attempt to boost that capital at risk, with a further burden on shareholders, in order to continue to shield debt holders from losses: it is, in effect, an unnecessary and costly incremental level of capital. However, as the charts show, it is not a shortage of capital but a shortage of capital at risk that is obviously the problem. Such a poorly thought out policy action will do nothing to alleviate moral hazard or reintroduce bank capital providers to the notion of risk
The logical outcome of such an argument is for regulators to force losses on both equity and bondholders — which indeed, some of them have tried to do, but mostly half-heartedly (think of the European Commission’s attempt at ‘burden sharing‘ for hybrid bondholders in banks).
What’s more, Marson reckons that once all capital is wiped out — equity and debt, but not deposits — regulators should take control of failed banks, ring-fence those deposits, and just start liquidating:
. . . A procedure where ALL capital providers (ex depositors) take losses, the taxpayer is removed from the capital structure altogether, and financial institutions can be taken apart, the good bits salvaged and the failed bits written off, seems far more capable of preventing a repeat of recent problems than an unnecessary levy. The bank levy idea is simply another way of shielding debt holders from losses and if bank debt is truly “risk free” that makes another crisis inevitable.
It’s an interesting point — and the tension between bondholders and shareholders in previous bailouts is an issue we think hasn’t yet received much regulatory scrutiny. However, we understand that the future of bank capital is currently being debated amongst several regulators, not least the European Commission and Germany’s Bundestag, which held a public hearing on the subject last month.
Expect more of this (rather dry) subject to come.
Related links:
Should bondholders be bailed-out? – Project Syndicate
Stellungnahme zum Gesetzesentwurf Umsetzung de der geänderten Bankenrichtlinie und geänderten Kapitaladäquanzrichtlinier (German) - Achim Dübel, Bundestag