The Minneapolis Plan – capital in excelsis

As discussed in our post of 1/12/2017, the Minneapolis Plan to End Too Big to Fail (Federal Reserve Bank of Minneapolis 2016) hinges on higher, and potentially significantly higher, bank equity capital requirements, marked against those currently in place under Basle III. The central argument of our post was that, unless set at a level that would produce a signal reduction in the supply of credit and other banking services, higher capital requirements alone cannot eliminate the risk of what we see as the core problem of finance — preventing the system-wide disturbances that can occur in periods when markets become disorderly, opinions are uniform, and contagion strikes. This view is driven by two considerations: (1) that a fair amount of risk may be generated outside or transferred outside the banking system, but might nevertheless affect the banking system somewhere down the line, and (2) our sense that higher capital requirements might not necessarily manifest as lower enterprise risk, and that, in fact, it is quite possible that higher capital requirements will spur a heftier risk appetite in order to lift returns, as well as more energetic attempts to circumvent the requirements. So we are led to the belief that it is unreasonable and unproductive to attempt — or claim that it is possible — to end TBTF, because the underlying conditions that drive its deployment might still be in place. Some more detailed thoughts on the Plan, and capital more broadly, are offered here.

Despite our skepticism about the ability to engineer an end to TBTF, we do come down on the side of higher capital requirements for large banks, defining higher as something in excess of what was in place before the Noughts Panic. What level of loss coverage is adequate? Have the moments of loss distribution functions fattened in the “capital markets era”? What about correlations? – questions we never tire of asking. According to a key IMF study (Dagher, Dell’Ariccia, Laeven, Ratnovski and Tong 2016), observations drawn from banking crises of the recent past indicate that 23 percent capital would not have covered losses in all cases. The IMF’s conclusion clearly has given shape to the Minneapolis Plan. From that perspective, fully-phased in levels of common equity Tier 1 capital (excluding the countercyclical capital buffer) under the current US regulatory regime — we’ll call that 4.5 percent minimum + 2.5 percent capital conservation buffer + 1.0 to 4.5 percent GSIB surcharges, total 8.0 to 11.5 percent, though de facto requirements depend on the bank’s internal capital plan set against results of the Comprehensive Capital Analysis and Review (CCAR) tests, whew —are insufficient to ensure ongoing solvency. The current US regulatory plan addresses this risk through a resolution regime, plus recapitalization through the TLAC category of long-term debt.

What seems to drive the Minneapolis Plan, and the seminal work of Anat Admati, Peter DeMarzo, Martin Hellwig and Paul Pfleiderer (2013) is a vision where extraordinary losses can be covered within the firm, without imposing losses on any claimant except for the holders of equity[1]. Another way of saying that the risk of default decreases with higher levels of capital — all else equal — is that solvency would be prolonged with higher capital. That raises a question about resolution triggers. Must a firm zero out its capital before being placed in resolution? The Minneapolis Plan (p. 47) reported that “(a) panel discussion…suggested that requiring government to shut down banks when equity is still positive would be a move to forcing more timely action.” Unless the trigger was well-defined in advance, how might that fly with bank management, employees, customers, and TLAC creditors, compared to a course of action that could stabilize the enterprise? For real-world insight into these matters, we recommend the statement of FDIC Chairman William Isaac[2] to the House of Representatives subcommittee investigating federal government assistance to Continental Bank – the hearings where the phrase Too Big to Fail was coined.

Or consider the bank with a 23.5 percent common equity capital requirement that has lost more than half of that capital in a crisis, has not been placed in resolution, and in an industry and economy that is unstable. How is it expected that the firm will get recapitalized? Is it impossible to conceive that a bank could need USD 50, 100 billion of capital in a hurry? What if it is more than one bank in that condition? As we see it, this is a key problem that TBTF has historically solved: finding new equity investment during a systemic crisis. The system has to sustain some level of stability, losses may have to be capped, to entice new outside money. It may be the case that only the government, through the central bank or the fisc, can make those assurances. It has been so in the past, and we reckon it will be so in the future.

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It is hard to move away from the position that bank capital is expensive relative to debt, unless supernormal profits and plenty of free cash flow are the norm. It should be kept in mind that equity has to earn a return, and has to be at least somewhat attractive compared to other stocks. It is not a good idea to try to chase big share price gains through fast growth. So return of capital through dividends and buybacks needs to be tolerated. That will be a drain on free cash flow, and it makes sense that regulators take this into consideration when setting de facto capital requirements.

The Modigliani-Miller (MM) promise, cited in key capital studies such as that by Admati et al. (2013), isn’t deliverable, and taxes aren’t the only friction making this so: incomplete disclosure and constant uncertainty preclude a more refined estimate of expected loss by investors. We have never been able to square the priority of loss allocation with the vision of equality of debt and equity under MM. The risk of rapid recapitalization seems hard to ignore; an equity investor can lose big even without default. These matters loom especially large for bank investors at a time when extraordinary government support is being withdrawn. That is, it can be safely asserted that the current environment for banks is perceived by market participants to be unsettled. It is unsettled. It would be difficult under such conditions to justify an unalloyed view that lower risk and lower ROE allow for pre-crisis enterprise values to be revisited. The recent run-up in bank stocks after the US presidential election is noteworthy in this regard.

Practitioners view capital as something of a deadweight. In normal times, its role in covering unexpected or extraordinary loss is unnecessary and therefore the question naturally arises as to how to minimize it. Expected losses are covered through classifications and reserves. A new accounting standard, Accounting Standards Update (ASU) No. 2016-13, Topic 326, Financial Instruments – Credit Losses, governs the treatment of expected losses. Allowance for losses/impairment should be part of any discussion of capital adequacy, and we hope to approach this topic in another post. US banking regulators have pointed out that the new standard does impact capital, in a FAQ document dated December 19, 2016 (Question 18, page 15). But not only bank managers look to economize on capital during periods of business-as-usual. Some capital-saving measures are sponsored by regulators and counterparties: the Basle III Countercyclical Capital Buffer, margin requirements, and even TLAC provide examples. Of course, there are severe limits to the prudence of such an approach, given the speed in which widespread distress can occur.

The drive to minimize capital within the firm is very strong. That drive is acknowledged in the Minneapolis Plan and some academic work (for example, Kashyap, Stein and Hanson 2010), where the refuge of non-bank financial structures is noted. Financial firms that operate with a minimum of capital continue to crop up. The heyday of securitization, when true sale was possible, sparked up significant numbers of stand-alone providers of mortgage, credit card, student and auto loans. Though true sale has been severely restricted in the wake of Statement of Financial Accounting Standards No. 166 and No. 167, the securitization infrastructure at broker/dealers remained in place, and now supports new web-based, thinly-capitalized originators. The emergence of firms that provide agented trading services is another example. Perhaps technology will displace the financial balance sheet altogether, and the only balance sheets that will remain will be those of the end users, i.e. households.

Scrimping on capital is a classic banking cheat, like funding short or “window dressing”. But there’s a balance to be struck, in order to divert energies away from circumvention, and to make compliance relatively painless for intermediaries, investors, and users of banking services. We posit that it is not deep-pocketed clients that need to fear the outcome of capital-driven balance sheet restrictions.

Footnotes

[1] For example, see (Federal Reserve Bank of Minneapolis 2016, 2): “We do not view improvements to currently proposed resolution schemes as a viable option (to end TBTF) because they focus on imposing losses on creditors during a crisis.” However, on page 14, it is stated that “…the new resolution regime could make it easier to address any remaining spillover concerns once the Minneapolis Plan has been fully implemented.”

[2] William M. Isaac, “Statement on Federal Assistance to Continental Illinois Corporation and Continental Illinois National Bank”, Hearings before the Subcommittee on Financial Institutions Supervision, Regulation and Insurance of the Committee on Banking, Finance and Urban Affairs, House of Representatives, Ninety-Eighth Congress, Second Session, September 18, 19 and October 4, 1984, Serial No. 98-111, pp. 457–469. US Government Printing Office. Digitized for FRASER, Federal Reserve Bank of St. Louis. http://fraser.stlouisfed.org/docs/historical/house/house_cinb1984.pdf

References

Admati, Anat R., Peter M. DeMarzo, Martin F. Hellwig, and Paul Pfleiderer. 2013. Fallacies, irrelevant facts, and myths in the discussion of capital regulation: why bank equity is not socially expensive. October 23. http://econpapers.repec.org/paper/mpgwpaper/2013_5f23.htm

Dagher, Jihad, Giovanni Dell’Ariccia, Luc Laeven, Lev Ratnovski, and Hui Tong. 2016. Benefits and costs of bank capital. IMF Staff Discussion Note No. 16/05. http://www.imf.org/en/Publications/SPROLLs/Staff-Discussion-Notes

Federal Reserve Bank of Minneapolis, 2016. The Minneapolis Plan to end Too Big to Fail. November 16. https://www.minneapolisfed.org/~/media/files/publications/studies/endingtbtf/the-minneapolis-plan/the-minneapolis-plan-to-end-too-big-to-fail-2016.pdf?la=en

Kashyap, Anil K., Jeremy C. Stein, and Samuel Hanson. 2010. An analysis of the impact of “substantially heightened” capital requirements on large financial institutions. http://faculty.chicagobooth.edu/anil.kashyap/research/papers/an_analysis_of_the_impact_of_substantially_heightened-Capital-Requirements-on-Financial-Institutions.pdf