Excess Bank Capital

 

After the planned new €24 billion equity capital injections are completed, the surviving domestic Irish banks will be highly capitalized, with equity-to-assets ratios[1] peaking at extremely high levels (above 20% except for BOI at 16%)  and then declining (after projected losses) to still high levels (baseline 10.5%). For details, see this Irish Central Bank report.  This puts Ireland in the vanguard of a new regulatory movement, across many countries, to impose substantially higher equity ratios on banks. There is strong and reasonably widespread support for this movement among academic economists and in financial regulatory bodies around the world. 

Is Ireland an appropriate test case for this new regime of much higher equity ratios? Higher equity ratios provide a safety buffer for bank depositors and bondholders, but they also provide a safety buffer for bank management. Troubled banks can fall into the “zombie bank” trap in which management squanders new funds endlessly, in order to preserve established banking relationships with failing clients and/or to hide their pre-existing losses. Around the world, state-owned corporations are legendary for their ability to waste shareholder (taxpayer) funds. Will the presence of unusually large equity buffers tempt the managers of state-owned Irish banks toward wasteful and/or politically expedient behaviour?

I have two main points to make in this blog entry:

1.      The enforced “over-capitalization” of Irish banks was the correct thing to do in the circumstances, but this new policy requires continuous monitoring.  There will be numerous pressures to waste the “excess” capital — these pressures need to be resisted.

2.     Ireland is now an important test case in the new international experiment with higher bank equity ratios.  No one can predict all the effects.

 

There are some big potential benefits from imposing higher bank equity ratios. By decreasing the degree of leverage implicit in bank equity, higher ratios limit any future hyper-profitability of the financial services sector, both from the perspective of shareholders and senior management. This might possibly limit the incentives to engage in excessively risk strategies. Also, since higher ratios force banks’ assets to be smaller relative to any fixed equity amount, they might help to shrink the bloated size of this recently very troublesome sector. Most importantly, higher equity ratios lower the likelihood of bank distress, and thereby lower the big external diseconomies associated with it. These external diseconomies come both from network effects (one bank in distress can freeze the entire trading network) and too-big-to-fail problem (governments are forced to socialized private bank losses).    

High equity ratios solve the too-big-to-fail problem in a roundabout way. Imposing high capital ratios effectively changes too-big-to-fail into very-unlikely-to-fail, since an over-capitalized bank should have a failure probability close to zero.  Related to this, perhaps the strongest argument for high capital ratios is the empirical finding of a cross-sectional statistical relationship linking low capital ratios (in December 2007) to subsequent distress (2008 and after) across individual banks.

Of course there are some drawbacks to higher equity ratios. There are good reasons for believing that increased equity ratios will raise the cost of loan funds. Sensible proponents, like David Miles of the Bank of England, argue that the overall growth impact of this increase in bank funding cost will be relatively small. Miles estimates that increasing bank equity ratios from 6% to 20% will only put a drag of 1/6 of 1% on GDP growth per year, less than a tenth of the offsetting benefits. More extreme proponents like Admati et al. claim that there will be absolutely no increase in bank funding cost after netting out tax benefits (which are a cost to the exchequer). This purist view requires an old-fashioned belief in neoclassical finance theory. 

The relevant tradeoffs are different for Ireland. A key motivation in the Irish case is to replace the government liability guarantee and the enormous ECB LOLR exposure to Irish bank debt with private sector bank funding. At a minimum, perhaps the greater safety provided by these high equity ratios might eventually help to end the slow steady drain of existing private sector funding of the banks. Another “advantage” (not from an Irish perspective) is that this bigger equity cushion improves the risk quality of existing ECB and Euro-area (French, German, etc.) financial institutions’ claims on the Irish banks. Also, the initially very high equity cushion (23% aggregate sector equity ratio) will partly be spent trying to solve the related liquidity problem of the banks, with forced selling of non-core assets at a loss in order to improve loan-to-deposit liquidity ratios.

Since they are now effectively state-owned, will Irish banks be tempted to waste their “excess” equity capital on management slack or political convenience? Special interest groups – mortgage holders, troubled Irish businesses with existing bank relationships, local and regional interests, unions, various business-related lobbyists – would all appreciate a piece of this potential €24 billion windfall. Eddie Hobbs has already earmarked the entire new capital infusion to be spent on helping out troubled mortgage holders:

“We have put in 24 billion euros, of the 70 billion that has gone in [to the banks], to deal with defaults on mortgages. We have tens of thousands of Irish families that are waiting for someone to come along, put them through this process, and relieve them of the debt.”

  –  Eddie Hobbs on the Marian Finucane Show on RTE radio 1st May 2011 (at minute:second 20:48).

That policy suggestion completely strips the banks of all their “excess” capital, and shows how easily it will be for banks to expend this new equity cushion.   

                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 


[1] There are numerous permutations of the bank equity ratio using various definitions of the numerator and denominator; I am referring to Core Tier 1 equity to risk-weighted assets.

14 thoughts on “Excess Bank Capital”

  1. Not far off 20 yrs ago the West laughed their socks off at the zombie / failed-incumbents-rule-OK tendencies in Japan.

    Was there ever any doubt that failures in banks would be so generously accommodated. Human behaviour is human behaviour. The money is there, it will be “used”.

  2. A further risk Gregory is the free ride for the rump equity in the hands of private shareholders. Even AIB still has a listing (on the junior market) despite having lost well in excess of pre-crisis book capital. If companies 100% owned by government can do bad things, companies 99% owned by governments can do extra bad things.

  3. Gregory Connor writes,

    There are some big potential benefits from imposing higher bank equity ratios. By decreasing the degree of leverage implicit in bank equity, higher ratios limit any future hyper-profitability of the financial services sector, both from the perspective of shareholders and senior management. This might possibly limit the incentives to engage in excessively risk strategies.

    Lets play a game. Pretend it is ten years ago, 2001. Lets pretend the higher bank equity ratios had been imposed in Ireland back then, through some glorious piece of luck, and suppose that Ireland had been spared as a country, the experience of an all-out banking system collapse. What else could go wrong in the Irish economy, with regard to financial institutions? Well, we know that elimination of hyper-profitability in Ireland’s banking sector, may have helped avoid the worst excesses of our recent asset bubble. But there still would have been an asset bubble. I believe that one of the most important announcements from the department of finance in Ireland, which featured in today’s Irish Times newspaper, if it had appeared in the same newspaper ten years ago, could have saved the Irish an untold amount of trauma and economic mayhem.

    It says in the Irish Times article, Financial information ‘to be pooled’, by Harrry McGee, A new condition in the draft memorandum of understanding states the Government will develop a legal framework that “would facilitate the collection and centralisation of financial information on borrowers”. In a strange way, I had argued that one of the strongest aspects of the policy, which saw the introduction of the National Asset Management Agency, a couple of years ago, was the way in which it did pool together for the first time, a major amount of information about borrowers. I believe, that is one of the main strengths of NAMA as a strategy. However, there question remains open as to how a mere 30 individual borrowers could soak up so much of the available credit in the first place. Whether or not, that had something to do with hyper-profitability of Irish banks, or dangerously low bank equity ratios, I don’t know.

    What I would argue, is that the large borrowers now contained in NAMA, effectively became ‘pack horses’ to the Irish banking institutions. What kind of policy is required, to avoid that eventuality, and what ways Ireland can improve the accuracy of its credit delivery system (non-existent at the moment), I will leave open for your debate or discussion. BOH.

    http://designcomment.blogspot.com/2011/04/pack-horse.html

  4. I’ve withdrawn most of the savings I had on deposit with Mr Noonan’s “twin pillars.” Not out of fear that the EIB might pull the plug, but precisely so as to do what little I could “to shrink the bloated size of this recently very troublesome sector.”

    I’m open to all suggestions as to how we can reduce that industry to a size where we can drown it in Grover Norquist’s famous bathtub.

  5. Whats the point ?

    Deposits are merely the artefact’s of credit creation – if banks continue to not produce credit the “deposits” will continue to decline ?

    Reserves therefore have no direct connection to credit creation – Ben Bernanke said recently modern banks don’t need deposits and he is right.
    Banks have only legal reserve requirements.

    This was a problem created in Basel and not in Ireland but who cares right ? – the ICB can continue to play with its soldiers if it wants.

    Previously the only relevant metric for a pre 1970s bank was the solvency of its country and thus the gov bonds held inside the commercial bank but this country is obviously insolvent but it does not matter as the sov paper is useless if it continues to recognize all liabilities – hint there are too many liabilties relative to sov paper.
    This may the real reason for recapitalisation via ICB injections as only if this new money has no real assets has it no liability.

    But do Irish banks even hold much irish paper ?

    The only thing priceless is the unnecessary complexity of banking operations.

    The central banks need to recapitalise through monetization of goverment bonds – nothing complex about this whatsoever.

    There is simply too many liabilties chasing the productive elements of this country and most others.
    The only leverage that matters is the credit ratio to the tax base period – everything else is hocus pocus.
    This will all flow back to the bullion banks eventually.

  6. @Kevin
    Stick it into a Post office bond as at least that money has velocity and is doing something.
    The term deposits in the banks are backing fictitious assets and are ruining the countrys commerce through the loss of the medium of exchange function of money.
    There is nothing seriously wrong with the country but flawed balance sheets.
    I know of one flat complex in Dennehys Cross Cork – half way between the CUH and UCC – a perfect location.
    It should be filled with workers who do not need a car to get to work but it just sits there with scaffolding adorning it for 2 or more years now !!

    This paralysis is grossly inefficient.

  7. @ Dork of Cork

    I find your contributions very enlightening and your sense of the absurb very appropriate for a very ridiculous and, not surprisely, painful time.

    “The only thing priceless is the unnecessary complexity of banking operations.”

    Try this one on for simplicity. What in the hell is the purpose of collecting taxes with all its complexity and cheating? All the state has to do is print money as allocated by the legislative body. I think you and Ben Barnanke are the only ones, aside from me, that might crasp the utter beauty of such a “system”.

  8. @ Kevin Donoghue

    For EIB read ECB of course.

    It’s interesting that the EIB has been a non-controversial positive force for good across Europe since 1958 but few know of it.

    @ Gregory Connor

    As for Eddie Hobbs on the Marian Finucane Show, maybe Eddie should round-up other well-off populists and use the millionaire presenter’s platform to launch a national appeal which they would generously subscribe to themselves.

    It’s time to change the script from the Government ‘must’ or ‘should.’

  9. You are right they could just print the stuff – the true purpose of taxes is to regulate demand and believe it or not make the gaff more efficient.

    Such as tax on petrol to prevent waste – therefore the CBs tries to keep the value of the currency intact.
    Now the banks produced too much credit relative to the sovergin – more taxes on labour will just reduce labour, tax take and so on.
    There only other option is to vapourise the liabilties but I doubt they would do that as they would lose control.
    In other words the only option is to monetize , monetize , monetize

    Although a hybrid option is to seperate the “risk assets” (ECB , remaining bondholders etc) –
    Transfer the term deposits directly to goverment and have a cash sale of the assets with the ECB taking the loss on their books.
    They are a central bank – if the worst came to the worst they could just bid up the price of Gold to make good their balance sheet.

    The lack of the keep it simple mantra in CBs byzantine operations suggests there is deception somewhere in the temple.

  10. What is most remarquable about the “new” Irish banks is not their excess capital but their absence of deposits!

  11. @ Overseas commentator

    You put your finger on it. As long as the solvency of the sovereign doing the capitalizing is in question, the position with regard to deposits will remain unchanged and the possibility of a sale of the banks remain very limited. The penny seems to be dropping very slowly with the new government that it simply cannot afford to be raising questions about the sustainability of the IMF/EU package if the economy is not to be saddled indefinitely with these zombie banks. It must buckle down and deliver the return to credibility itself.

    I am neither a banker nor an economist but these facts seem self-evident to me and to others in Ireland, many of whom are simply shifting deposits out of the banks in question (although the numbers for ordinary depositors doing so remain low as we all need retail banking services).

    What is even worse is the fact that the longer there is a failure by the establishment to grasp the reality and the seriousness of the situation the greater the dangers identified in the very informative contribution by Gregory Connor.

    I wonder if there should not be the equivalent of the Hippocratic oath on the lines of “do no harm” for new governments. We have a collection of neophyte ministers – curiously all from the larger party in the coalition – trying to make a name for themselves with one silly scheme after another and little sign of any central control.

    At least, the damaging and mis-directed assault on the ECB seems to be running out of steam.

  12. @ Gregory Connor

    The debates on the other threads having gone rather tiresomely totally off topic, I am posting this link on Intra-eurosystem debts by John Whittaker of Lancaster University here. You may find it of interest if you have not already seen it.

    http://www.lancs.ac.uk/staff/whittaj1/eurosystem.pdf

    How to get out of this bind? That is the conundrum for the ECB and euro area governments. The opinion of the ECB on the ESM published on 17 March is of interest in this respect.

    QUOTE With respect to the role of the ECB and the Eurosystem, while
    the ECB may act as fiscal agent for the ESM pursuant to Article 21.2 of
    the Statute of the European System of Central Banks and of the European
    Central Bank (hereinafter the Statute of the ESCB), in the same way as
    under the Unions Medium-Term Financial Assistance Facility4, the EFSM
    and the EFSF, Article 123 TFEU would not allow the ESM to become a
    counterparty of the Eurosystem under Article 18 of the Statute of the
    ESCB. On this latter element, the ECB recalls that the monetary
    financing prohibition in Article 123 TFEU is one of the basic pillars of
    the legal architecture of EMU5 both for reasons of fiscal discipline of
    the Member States and in order to preserve the integrity of the single
    monetary policy as well as the independence of the ECB and the
    Eurosystem UNQUOTE.

    Translated: this idea is was decided by you governments and is your responsibility alone.

    QUOTE …in full compliance with the Treaties, the ESM should be granted the capacity to employ an appropriate range of instruments in order to be
    able to effectively fight against contagion in situations of acute
    market instability”.UNQUOTE

    Translated: the ECB is not equipped to be the fire brigade for the entire euro area financial system and neither is any central bank in terms of national financial systems i.e. give the ESM the tools that it needs, including the capacity to intervene in secondary markets.

    QUOTE In addition, and even before its entry into force, the text of
    the new Article 136(3) TFEU helps to explain, and thereby confirms, the
    scope of Article 125 TFEU with respect to safeguarding the financial
    stability of the euro area as a whole, i.e. the activation of temporary
    financial assistance is in principle compatible with Article 125 TFEU
    provided that it is indispensable for such safeguarding and subject to
    strict conditions. UNQUOTE

    Translated: the pending decision by the German Constitutional Court, if it contradicts this view, has the appropriate consequences i.e. a very confused German position.

  13. @ Gregory Connor

    Herewith a PDF vesrion of the ECB opinion.

    http://www.ecb.int/ecb/legal/pdf/en_con_2011_24_f_sign.pdf

    I need hardly add that my opinions in this matter have been influenced by the Whittaker paper and, in particular, the follwoing comment.

    “The large expansion of CBI debt to th eurosystem is a result of its banks’ loss of deposits, maturing debt that they have been unable to refinance and limited access to the interbank market. This follows doubts about the banks’ solvency and about the capacity of the Irish government to honour its guarantee of its banks’ liabilities”.

    Does this also hold true of Portugal although the situations of the two countries are very different? I am not technically competent to judge. But, if so, there is something amiss in the operation of the euro which needs urgent attention.

    It is, it seems to me, the problem identified by Winkler. Until 1913 the US was a country without a central bank, the ECB is a central bank without a country and with no likelihood of one emerging in the immediate future. The ESM is the presumed stopgap. However, the shilly-shallying way in which Germany is approaching its construction seems destined to wreck it even before it gets off the ground.

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