Greenspan’s 15% survival formula

April 9, 2010

I believe that during the past 18 months, there were very few instances of serial default and contagion that could have not been contained by adequate risk-based capital and liquidity. I presume, for example, that with 15% tangible equity capital, neither Bear Sterns nor Lehman Brothers would have been in trouble. Increased capital, I might add parenthetically, would also likely result in smaller executive compensation packages, since more capital would have to be retained in undistributed earnings.

-Alan Greenspan*
FCIC Testimony, 4/7/10

(Click here to enlarge)

greenspan TCE

It’s a question on everyone’s mind: how much capital must banks be made to hold? No other regulatory change can do as much to prevent another financial collapse. A bigger equity cushion not only buffers bank creditors from losses — preventing cascading bank runs — it by definition would reduce frothy lending that inflates bubbles in the first place.

The issue has new immediacy today, in the wake of revelations published by WSJ that major banks are masking their leverage. Because balance sheets are reported at a single point in time, i.e. the last day of the quarter, there’s an incentive to reduce risk around that particular day in order to present a pretty face to the world. Meanwhile, during the quarter banks are jacking up leverage in order to boost profits. While Lehman actually hid leverage (with Repo 105), other banks are temporarily reducing it, “understating debt levels used to fund securities trades by lowering them an average of 42% at the end of each of the past five” quarters.

This is just another reason that, when setting new capital standards, regulators should err on the high side. Not only are banks sitting on large embedded losses with the help of extend and pretend accounting, there’s now strong evidence they’ll game whatever standards are set.

But what’s the right number? Few have been willing to commit to a figure. For instance, while the Basel Committee of international bank regulators has proposed strict new definitions for capital — and liquidity — it has yet to tender suggestions on precisely how much banks should be made to hold.

It’s notable that Alan Greenspan says 15% tangible equity would have been a good cushion for Lehman and Bear. Extrapolated across other major banks, the 15% figure implies they’d have to raise nearly $900 billion, a truly stupendous figure.

That’s so high, it’s hard to contemplate the implications. Suffice it to say, it’s not happening. Banks couldn’t come close to raising such sums even if they were commanded to by regulators. And such a draconian standard would hammer lending. I argued in my Breakingviews column yesterday (paywalled folks, sorry!) that regulators need to be concerned with raising capital standards, not lending levels, which are conflicting goals. But 15% TCE is a bit much.

But in setting a very high bar, Greenspan may have done regulators a favor. Perhaps it will give them cover to raise capital standards higher than they otherwise would. When banks inevitably complain, regulators can retort that they’re cutting them more slack than The Maestro would!

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*Hat tip to HuffPo’s Shahien Nasiripour for spotting this in Greenspan’s testimony.

Comments

Aren’t historic reserve requirements for fractional reserve banking systems around 10%? Guess it doesn’t matter with Bernanke pushing for 0%. Ugh.

Banks need to have enough capital and vault cash to operate and meet customer needs without Fed help, overnight loans, FASB changes, and Enron-like balance sheet gimmickry. Or else they get shut down.

Probably too much to ask for in this environment.

Nice piece Rolfe, pretty shocking how much money they’d need to raise to hit 15%.

Adam
Bearishnews.com

Posted by Sharpie | Report as abusive
 

The 15% is half of the equation. Underlying standards for off balance sheet transactions and the quality of the 85% are just as important. I think historical norms should be used as a starting.

15% is the easy part to manage. The quality and requirements to retain a piece of underwriting on the balance sheet to full term might be another requirement. Ethics and responsibility are tougher to regulate. the risk metrics are a good start. The real trick is to have banks retain more risk than they try to diversify away under false pretense using structured and syndicated instrument type approaches. Retained issuance means one eats there own dog food, instead of packaging it for others and having the ratings agencies slap an AAA label on the can.

Posted by Nick_Gogerty | Report as abusive
 

If you don’t simply give up and assume the Govt as LOLR, then you are left with expensive choices for the financial concerns. You will either have very large capital requirements or very expensive insurance. After all, since you’re trying to insure taxpayer losses in the face of a severe crisis, it’s bound to be awfully expensive. Indeed, that’s why investors in a crisis demand govt guarantees. The govt has or can get the money. Good luck with these little debt to equity schemes, which was also prove very expensive to incentivize.

Posted by DonthelibertDem | Report as abusive
 

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