High-cost, low-return bank capital

By Felix Salmon
February 17, 2010
William Wild has a great little paper up, disputing the widely-accepted idea that the best form of regulatory capital, for banks, is common equity. It isn't, he explains: shareholders have a strong incentive to maximize leverage and risk. They don't make banks safer, they make them riskier.

" data-share-img="" data-share="twitter,facebook,linkedin,reddit,google" data-share-count="true">

William Wild has a great little paper up, disputing the widely-accepted idea that the best form of regulatory capital, for banks, is common equity. It isn’t, he explains: shareholders have a strong incentive to maximize leverage and risk. They don’t make banks safer, they make them riskier.

In its place, Wild proposes a form of regulatory capital which, far from having the large potential upside of shares, has no potential upside at all. Essentially, it’s just cash, invested in risk-free assets, throwing off a very modest income stream for its owner, and which can’t be repaid or redeemed. Yet if the bank gets into trouble, all that cash would go towards absorbing losses before there’s any default.

Such capital would not be attractive to investors. But, says Wild, that’s a feature, not a bug:

Irrespective of form, there is no doubt that the required up­front premium or discount would be substantial. The perpetual instrument would provide, at best, an ongoing risk free rate of return but with clearly material levels of risk. To bemoan this high cost is, however, to miss the point. The highest quality form of regulatory capital will be expensive, given what it is required to do. As has been amply demonstrated, cheaper forms of regulatory capital are simply poorer at performing the function.

Yes, says Wild, the high cost of this capital will end up in higher borrowing costs for the people that banks lend to. But that’s also an increase in transparency: the hardest part of any bank’s loan-pricing operation is trying to come up with a cost of existing equity, while the cost of this new instrument will be much more obvious and easy to calculate.

Finally, says Wild, this new instrument is much less pro-cyclical than bank equity. When banks get into trouble, they tend to stop lending, rather than increase their capital by issuing dilutive new stock. And since banks generally get into trouble when the economy is doing badly, the decrease in lending only makes macroeconomic matters worse.

By contrast, Wild’s new form of regulatory capital could be issued much more easily, with a much smaller hit to shareholders — doing so might not even require board approval, if the cost of buying new capital could be incorporated into the terms of some new loan to a customer.

In general, I like the idea of a high-cost, low-return form of bank capital. When it comes to macroprudential regulation, you can’t let market rules like the link between risk and return drive everything.

Update: If the SSRN link doesn’t work, the paper can also be found here.

More From Felix Salmon
Post Felix
The Piketty pessimist
The most expensive lottery ticket in the world
The problems of HFT, Joe Stiglitz edition
Private equity math, Nuveen edition
Five explanations for Greece’s bond yield
Comments
7 comments so far

I don’t get it. At all. Is this satire?

Posted by Sandrew | Report as abusive

how about just raising reserve requirements (like china is now doing)? http://online.wsj.com/article/SB10001424 052748703699204575017462822204340.html – “Free marketers blanch at the idea of more regulation. But banking isn’t a normal market. Banks create money when it did not previously exist. We’ve built a regulatory structure around this sleight-of-hand and each time are astonished that banks still fail. I doubt we will ever get to no leverage, a dollar loan backed by a dollar of capital, but I think Mr. Bernanke could be headed in that direction. One potential target is a 5 to 1 leverage limit—he could increase reserve requirements by 1% per year until it hits 20% by 2020. With credit dear, perhaps banks will do a better job of deciding what is a ‘sure thing.’”

Posted by loph4t | Report as abusive

I thought covered bonds were supposed to patch everything up.

Posted by Uncle_Billy | Report as abusive

This form of capital would work for deferred comp purposes too. The current practice of paying deferred comp in the form of common shares or options just “incentivizes” management to swing for the fences to maximize the value of their equity holdings. Paying in a form of equity that can only decline in value clearly aligns management’s interest with long term stability.

Posted by BoringCdn | Report as abusive

I read the article and the post, but I still don’t understand who is going to pay to put this capital in place or replenish it after losses. It’s quite clear that no one wants to be in a first-loss position for low yield, so someone has to pay up-front cash to get the capital into the bank. That cost will be born either by borrowers or equity-holders. These are the same parties that ALREADY bear the cost of bank equity/capital requirements. Why would giving their burden a different name and creating some regulation change banking practice when the market participants are still the same people? What could we offer capital-providers that would be a more effective set of incentives than the current equityholder incentives?

Posted by najdorf | Report as abusive

This is just bizarre. If banks are properly regulated and properly run they should have no problem attracting (normal) capital.

For a sensible take on banking reform see Mosler here:

http://neweconomicperspectives.blogspot. com/2010/02/warren-moslers-proposals-for -treasury.html

Posted by Sensei | Report as abusive

As author of this paper I just wanted to make two general responses to the comments.

1. Equity represents the ownership interest in a bank. The purpose of regulatory capital is purely to absorb bank losses. There is no reason they must be the same thing.

2. Some of the comments on pricing and the availability of capital imply a faith in the efficiency/perfection of markets, and the effectiveness of market discipline, that those commenters would probably not defend in other contexts.

At the very least, the fact of the GFC, the need for bank regulation at all, and even the very existence of banks themselves (let alone as such as huge % of GDP), mean there are more than enough inefficiencies and imperfections in the market to justify a view that one form of capital instrument may be more effective than another in meeting a particular set of objectives.

Regards
Will

Posted by will1 | Report as abusive
Post Your Comment

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/