Bank capital and short-term greediness

By Felix Salmon
March 15, 2012
James Saft has a very smart take on Greg Smith today:

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James Saft has a very smart take on Greg Smith today:

Goldman was able to make long-term greedy work because, in the view of those working there at the time, that was the best kind of greedy they could get their hands on. Burning clients wasn’t so much wrong as stupid…

Careers in banking are wasting assets; someone will only get so many bites at the apple, and is far less likely to be at the same firm than they were in Gus Levy’s time. The industry too, it is important to understand, is also a wasting asset; it is shrinking and may well shrink substantially from here. Ironically, that may well mean it is even more rational for bankers to burn clients.

It’s notable that Smith’s lament appeared as Citigroup’s Vikram Pandit scrambled to get back onto his feet after his plan to return capital to shareholders was knocked down by shareholders.

Pandit wants to return capital to shareholders because they clearly value that capital much more highly in their own hands than they do in his. Each of my dollars is worth $1. Each of Citigroup’s dollars, by contrast, is worth just 58 cents: that’s the price-to-book ratio that Citi’s trading at right now.

As a general rule, when banks are worth much more than their book value, long-term greedy makes a fair amount of sense: each dollar you make for the company becomes worth much more than that when looked at through the lens of the present value of the franchise value that dollar represents. When banks are trading at a substantial discount to book value, on the other hand, it makes just as much sense for employees to extract as much money from them as they can, as quickly as possible. And shareholders too, for that matter. That’s why Vikram wanted to give them their money back.

This mindset is indicative of a broken system, as Anat Admati explains:

If a strong bank retains its earnings and invests prudently, shareholders are still entitled to the profits from these investments, as long as debts are paid. Many successful companies do not pay dividends for extended periods of time, and their stock prices reflect their good investments. When banks distribute profits to shareholders and continue to borrow, they create more risk. This pollutes the interconnected financial system by increasing its fragility. If banks do not want to invest the profits, they can use them to pay down some of their debts.

What this says to me is that the entire banking system, from Citi to Goldman (which itself is trading at just 0.92 times book value), is locked into a vicious cycle of short-term greed, where everybody from traders to shareholders is trying to get their money out as quickly as possible, and regulators are fighting a rear-guard action trying to prevent them from doing so. It’s fundamentally dysfunctional and adversarial, with bankers pitted against both regulators and their own clients. And yet at least at the biggest banks, like Citi and Goldman, it might ultimately help to shrink them down to less dangerous size.

What regulators should be doing, I think, is encouraging the likes of Citi to give back capital to shareholders — just so long as the bank’s capital ratios go up at the same time. In a word, deleveraging. The lesson of the 2008 bailouts is very much that no matter how much capital you inject into banks, they won’t lend it out in the real economy. So let’s allow that capital to leave the banks, return to shareholders, and get invested in the economy some other way. Just so long as when that happens, the big banks shrink commensurately.

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Comments
7 comments so far

Is that “book value” truly representative of their assets? Or is it filled with hot air and bloated valuations?

Moreover, book value is meaningless if you get hit with a liquidity crunch. There are plenty of good reasons to prefer that a bank hold on to its cash.

If you look closely, I think you will find that investors don’t value all parts of Citi’s books equally. Dollars held in cash are (or should be) valued at a 1:1 ratio. Dollars held in questionable derivatives are valued much more cheaply. That 0.58 is the average, not a universal multiplier.

Most damaging to investors would be the scenario in which Citi distributes $10B of cash to investors, then is forced to raise another $10B of cash through a stock offering. You get massive dilution when a stock is trading at a fraction of book value.

Posted by TFF | Report as abusive

This “give cash back to shareholders” meme is almost a Wall Street war cry, it never seems to come from actual shareholders, just “sources” in the financial community. You’re right though the adversarial nature of the financial system has some exposed weaknesses at the moment, but will they get fixed? Somehow I doubt it…

Posted by FifthDecade | Report as abusive

“What regulators should be doing, I think, is encouraging the likes of Citi to give back capital to shareholders — just so long as the bank’s capital ratios go up at the same time. In a word, deleveraging.”

If banks give capital back to shareholders, won’t their capital ratios go down? Won’t banks only achieve deleveraging if they use that capital to pay off their debts? Am I missing something here?

Posted by TheDollarGame | Report as abusive

“everybody from traders to shareholders is trying to get their money out as quickly as possible, and regulators are fighting a rear-guard action trying to prevent them from doing so”

Really? It seems like regulators, for the most part, are bending over backwards to avoid seeing the looting happening right in front of their faces. They’re like Mob lawyers who know what their clients are up to but have to pretend otherwise in public. I mean, srsly, where are these “actions” of which you speak?

Posted by Moopheus | Report as abusive

Felix,

“So let’s allow that capital to leave the banks, return to shareholders, and get invested in the economy some other way.”

This is what banks DO (intermediate between savers and borrowers). So, per your comment, why HAVE ‘C’?

Per TFF’s post above, break it up (the consumer finance business and the global cash mgmt. product from the derivatives casino)

Posted by crocodilechuck | Report as abusive

Anyone who gets taught by Anat Admati should demand their money back. I have never read anything intelligent by her and she seems to have a complete lack of any insight in to her field. Sure there exist companies that don’t pay out dividends but they are “growth” companies. You gonna stick your cash in a company who isn’t growing and isn’t paying dividends? A company that is merely paying down debt?

FifthDecade, seriously? Investors in C are DEMANDING that it simply pay down debts to become “more stable”? What investors do you hang out with?

Posted by Danny_Black | Report as abusive

Why larry summers shouldn’t become head of the WB: http://mathbabe.org/2012/03/11/why-larry -summers-lost-the-presidency-of-harvard/

Posted by Foppe | Report as abusive
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