Nocera vs Sorkin, bank capital edition

By Felix Salmon
June 21, 2011

One of the consequences of Joe Nocera’s move to the NYT op-ed page is that his column now appears on the same day as that of Andrew Ross Sorkin. Which can sometimes result in a great lesson on the difference between how Wall Street is viewed from the outside and how it is viewed from the inside.

Nocera devotes his column today to Basel III, which is of course fantastic — he’s quite right that the fight over capital standards is much more important than any wrangling over Dodd-Frank, or derivatives, or the Consumer Financial Protection Bureau. Capital is crucial, it’s insufficient at present, and Nocera’s right that asking too-big-to-fail banks to hold as much as 14% of their assets as equity is a very good idea.

(One point I’d add: these capital standards have to be progressive, a bit like income tax. The last thing we want is a situation where too-big-to-fail banks have an incentive to get even bigger, on the grounds that if they’re going to be socked with the highest capital surcharge anyway, they might as well just get as big as they possibly can. So my suggestion is for the SIFI surcharge to range between 3% and 7%, giving banks an incentive to shrink and thereby get a lower rate.)

Nocera also links to the smart analysis of Anat Admati, who explains that there’s no good reason for banks to minimize the amount of equity they hold:

JPM’s overall funding costs, averaging the required return on the various debt claims it issues (some of which might decline if JPM is better capitalized) and the required return on equity, need not change just because more equity is used.

In other words, it’s a really bad idea to encourage banks to minimize the amount of equity they have, or to look at banks’ profits solely as a percentage of their total equity, rather than in relation to their entire funding structure. If you want to look at profitability, then return on assets is a much smarter place to start than return on equity.

Which brings me to Sorkin:

Wall Street is facing a new reality that it has yet to come to grips with. “Return on equity,” perhaps the best metric for considering the health of the Wall Street, fell to 8.2 percent in 2010, according to Nomura. That is down from 17.5 percent in 2005, before the crisis.

By comparison, total compensation has hardly fallen at all. At Goldman Sachs, for example, compensation and benefit expenses fell 5 percent in the first quarter… And its annualized return on equity fell to 12.2 percent from 20.1 percent in the period a year earlier.

Andrew is, simply, wrong on this. Return on equity is not “the best metric for considering the health of the Wall Street”, precisely because it makes equity seem like a bad thing which should be minimized, rather than a good thing which should be maximized.

More generally, looking at total compensation as a percentage of total equity is rather silly. What direction does Sorkin want that ratio to move in? He seems to think it a bad thing that it’s going down — but isn’t a world where bankers are less overpaid and equity is more abundant exactly what we want?

Sorkin’s bigger point is that higher base salaries (to make up for lower bonuses) are “perverting Wall Street’s calculus during periods of weakness”. Which rather forgets that Wall Street’s calculus was pretty perverted before. The current system is definitely an improvement: it forces banks to hire people for the long-term value they create, rather than for the short-term quarterly profits they can generate before cashing their eight-digit bonus checks and quitting for a life of leisure.

And, since when is this a “period of weakness” for Wall Street? Hasn’t the banking sector been wallowing in cash dropped from Ben Bernanke’s helicopters for the past couple of years? This is a period of strength for Wall Street, and the biggest banks are making record profits. If they’re firing people, maybe that’s a good sign that they reckon they can get by without employing quite as many of America’s best and brightest. And that in turn is a development to be welcomed, rather than criticized for its perversity.


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

“Hasn’t the banking sector been wallowing in cash dropped from Ben Bernanke’s helicopters for the past couple of years? This is a period of strength for Wall Street, and the biggest banks are making record profits.”

Come on, Felix — you do this for a living, so how can you be so wrong? Citigroup and Bank of America are not making “record profits” by any stretch of the imagination — in fact, they’re barely profitable. Goldman’s profits are down, as are Morgan Stanley’s. There’s no sense in which this is a period of strength for Wall Street — it’s just treading water until the economy recovers and demand for loans starts rising again.

Posted by FBlair | Report as abusive

Agreed. In retrospect, banks were grossly undercapitalized in 2005. Even though the meltdown happened a couple years later, the practices that led to that meltdown were already in place. So if banks were undercapitalized in 2008, they were undercapitalized in 2005.
Ergo, their ROEs were artificially high.
And if I may be a codger for a moment: Too big to fail is a new term to cope with an old idea. There have always been a cadre of companies whose failure was a systemic risk.
In the 20th century, these companies were utilities – Ma Bell and the power companies. And they were quite heavily regulated, although the regulation was handled such that they created a hefty, stable return for investors. And their stocks were boring and predictable “granny stocks” favored by retirees.
But the utilities made a lot of money and when you picked up a phone you got a dial tone and when you flipped a switch, a light came on.
Technology has made regulation of those old utilities obsolete, but I think the exercise makes it clear that government can regulate important industries in a way that protects both investors and the public interest.

Posted by RZ0 | Report as abusive

I know this is a BLOG and we’re not supposed treat what is written here as actual informed journalism but this is just rubbish.

Sorkin is a mouthpiece for Wall Street, nothing more and nothing less. You can bet that Wall Street cares very much about ROE, because it effects stock prices. Falling ROE means falling risk adjusted returns, which means less comp. Thats it, there is nothing more to understand.

While its true that big banks remain woefully undercapitalized for the risks that they are taking, if Basel III is passed at anything close to what is being floated about (which will never happen by the way), then the big banks are really screwed because they will not be able to leverage up their balance sheets to earn huge pay bonuses and their perpetually low ROE’s will cause them to shrink rather than grow assets (the wrong direction if you are a rational Wall Street CEO). Remove low interest rates and it looks even worse for the banks. That is why they are all trading at or below tangible book value, falling ROE….

So when Sorkin talks, please don’t be such an idiot as to pre-suppose that they’re is any actual thought in his head other than being Blankfein’s Butt Boy, you should know better.

Posted by TeddyKGB | Report as abusive

@Fblair, I think Felix should have worded that second sentence you quoted a little differently. Instead of focusing on bank profits, he should have been talking about the compensation of the financial industry, which is at record levels. Which is absurd, given that your statement, which I believe is true, that banks are not earning record profits, exposes the lack of accountability of financial executives and the correlation between their performance and compensation.

But the first sentence is true – the banks are wallowing in cash provided by the Fed. The Fed is virtually paying for the ridiculous compensation being awarded (not earned) in the industry.

Posted by KenG_CA | Report as abusive

Only an idiot thinks that in the event of a freezing of the commercial paper market that ANY capital reserves would have been enough. Capital reserves are an utter red herring. Anyone with any sort of knowledge about banking knows liquidity is key.

Ms Admati basically wrote a paper using a version of the widely discredited CAPM and applied it to banking. If it was not for the fact this nonsense fit four square behind your own prejudices then you would be laughing at the assumptions it makes, assumptions by the way that were roundly proven to be wrong in the last crisis.

Posted by Danny_Black | Report as abusive

Danny, if the capital reserves were high enough, the commercial paper market may not have froze up. There was more debt being issued before the crash than the system could support, and a freeze up was inevitable. If there were lower limits on the amounts banks were allowed to lend, they would have been more selective about who they lent to.

also, correct me if I’m wrong, but weren’t some banks (like Lehman) lending out >30x their capital? Don’t you think that’s incredibly risky?

Posted by KenG_CA | Report as abusive

The saddest thing is that Sorkin doesn’t seem to understand undergraduate-level finance.

@Danny_Black: The foundation of the paper is based on a rather well-established literature in corporate finance that began with the Modigliani-Miller theorem, not the CAPM. Banks themselves use variants of this very same theory to determine their capital structure and estimate their cost of capital. Also, there is a long discussion in the paper about the role of short-term borrowing and the commercial paper market. But I guess you would have known that if you’d actually read the paper.

Posted by framed | Report as abusive

KenG_CA, and back in the 18th and 19th century when they had far far higher capital reserves than even Admati is demanding. Didnt stop them going bankrupt.

Framed, MM has exactly the same assumptions as CAPM. In fact when i learnt it MM was derived from CAPM. Hands up everyone who is happy with the assumptions MM makes:

1) Efficient market,
2) Random walk asset prices
3) Equilibrium
4) Static covariances
5) Risk-Reward curves

Yeap banks do use it for the same reasons they use VaR, because it is a simple model that even a buysider and regulator can understand. You can be sure they use a more sophisticated approach internally and on the cap structure arb desks.

I might not have read the actual paper, I read this one, so maybe there is a much more rigorous version out there I missed. If so, will happily read it, go out buy a hat and eat it: ers/library/BankEquityNotExpensive.pdf

Alot of ASSERTIONS, not much actual proof. For instance, a bank with more equity financing is less risky than one with less. Really? Care to back that up with examples from 2008?

Equity issuance is not expensive when forced? Really? Because that worked a dream in 2007-2009. She see the cost of TARP funds for say GS? Because if she has then she clearly hasn’t been using the OED version of “cheap”

Posted by Danny_Black | Report as abusive

Danny, I’m sure they had less regulations, oversight, and auditing overall back in the 18th and 19th centuries. That’s not a fair comparison.

Posted by KenG_CA | Report as abusive

Not only did they have less regulation, oversight, etc., they held each and every loan they made on their own balance sheet and no FDIC.

Posted by framed | Report as abusive

KenG_CA, my point is that capital reserve ratios have a very tenuous relationship with the stability of the banks. The paper quoted is making a straight out claim that if a bank has more equity – and incidentally making an assumption about the continuity of change in the value of that equity – vs the liabilities, which again the values of which are assumed to be continuously changing in a very specific way, then the “risk” should be lower and that is clearly and obviously and demonstrably false. Once you chuck that “fact” out the window, you are not left with terribly much. Of course, I never did undergraduate finance or economics with all those fancy straight lines and secondary school level probability, otherwise I am sure I would be far more impressed by a theorem that requires that I can borrow an infinite amount of money at the same rate as Uncle Sam.

Posted by Danny_Black | Report as abusive

Framed, throw in no taxes, a unique interest rate and asset prices following a brownian motion and you pretty much just listed the key assumptions behind MM. How did holding more equity=less risky work out for those banks?

Posted by Danny_Black | Report as abusive

“Andrew is, simply, wrong on this. Return on equity is not “the best metric for considering the health of the Wall Street”, precisely because it makes equity seem like a bad thing which should be minimized, rather than a good thing which should be maximized.”

That is completely wrong. Equity to a bank is like capital to a manufacturing company. If you keep buying more capital net income goes up but returns may be the same.

So obviously ROE is the most important ratio you idiot.

Posted by Smarsy | Report as abusive

Danny, under the pseudo-intellectualism you are still just a shill for the interests of bankers. They don’t want to hold more equity capital because their comp model is driven by the heads-I-win/tails-you-lose approach of allocating a large portion of leveraged gains to insiders and a large portion of leveraged losses to outside shareholders, taxpayers, and if absolutely necessary after bleeding the Treasury dry, bondholders. More capital would cause banks to make less money in good times and inflict fewer losses on taxpayers/bondholders in bad times. To the extent that bankers rebel against these capital strictures and want to run a hedge fund levered 30-1 with a clear absence of government backing, they are welcome to attempt to borrow hundreds of millions of dollars at tight spreads to Treasuries and strive to keep the doors open through the next -20% downturn in the markets where they play. If they’re going to play in the regulated/back-stopped financial space after inflicting huge losses on taxpayers and investors, and benefit from the cheaper access to debt and liquidity support in crises, they should get ready for some more regulation.

Posted by najdorf | Report as abusive

najdorf, thanks for not resorting to “pseudo-intellectualism” and going straight to talking BS. You are aware of course how much banks have “cost” the taxpayer, once you strip out Freddie and Fannie?

As for more regulation, what makes you think banks don’t like it? If it wasn’t for kneejerk, poorly thought out regulation to satisfy idiots like you most of the derivatives market and ALL of the structured products market would never have existed. We wouldn’t have had SIVs tapping the CP market for less than a year so that would count as a “risk-free” loan.

But keep that outrage warm, secure in the knowledge that not a single fact backs you up.

Posted by Danny_Black | Report as abusive

TeddyKGB, you must be a shill for banking interests because increased equity financing causing decreased ROE leading to depressed share prices is what they are claiming and what Admati “proved” is not true and which Mr Salmon via Nocera was claiming. Does that mean you are also Blankfein’s butt boy? Readers deserve to know!!

Posted by Danny_Black | Report as abusive

Ask yourselves: “If I was a responsible bank regulator, what would cause me to lose most sleep at night, the excessive lending by banks to what was perceived as risky or the excessive lending by banks to what was perceived as not-risky but that could in fact be very risky?”

Once you have answered the previous question as it must be answered, and then analyze how the current capital requirements for banks are based on treating what is perceived as not-risky as if it really was not-risky, then you will begin to understand the monstrous mistake committed by the bank regulators. kc&feature=player_embedded

Posted by PerKurowski | Report as abusive

“looking at total compensation as a percentage of total equity is rather silly. What direction does Sorkin want that ratio to move in? He seems to think it a bad thing that it’s going down — but isn’t a world where bankers are less overpaid and equity is more abundant exactly what we want?”

I’m no fan of Sorkin but I think you are mischaracterizing his point here. I think he is suggesting it is a problem that the total compensation/equity ratio has NOT declined along with return on equity

Posted by chris9059 | Report as abusive