Capital Requirements for Banks

On July 10, 2009, the Economist writes about the need for increased capital requirements for banks.
Interestingly, in all its writing about the financial crisis and its resolution the reputed weekly is shying away from tough questions. Ironically, it writes “politicians seem not to have the stomach for the fight” for more radical changes. Indeed political will is the main issue today with the tough love necessary for our financial businesses.
One of the main conclusions of my research is that a carving out and nationalization of commercial banking assets from our financial superstores is doable and necessary: never mind too big to fail, too big, period. Our large money-center commercial banks, cum hedge funds have to be broken up along institutional lines (Glass Steagall II). These banks are running different business models on one common platform, under one roof with distorted compensation structures, applying inadequate risk models, relying on meaningless internal risk management tools and are driven by enormous corporate and individual leverage.
Government has to reshape the structure of our financial system, it has to take over and restructure failed institutions, which does not mean that it needs to run these banks. It means government controls the board and drafts management and compensation contracts that are symmetric and measured. Ownership does not equal management. With new rules in place, these banks should be re-privatised almost immediately.
The Economist also bemoans that higher capital requirements will lead to higher interest rates. The point is completely off the mark. Why?
First, interest rates will rise eventually no matter what. By now it should have become clear to everyone that the interest rate environment of the past decade was the result of the extraordinary amount of liquidity provided to the system. A reversion to sustainable levels is not debatable, it is only a matter of time.
If borrowing rates are lower than the cost of equity capital, the higher the leverage, the lower interest rates will be in the system.  Part of the reason we enjoyed historically low interest rates was precisely the enormous leverage we built. Using it as an argument against reducing that leverage is quite silly, really.
Second, Banks’ assets have a very diverse risk structure. The conversion of interest rates amidst the collapse of risk differentiation was one of the main distortions in the system fuelled by its myopic treatment of risk. Commercial banking, by its very nature is low risk, direct relationship banking that thrives on scale and sound organizational structures (one reason why mortgage lending was assumed to be very low risk deep into the sub-prime mess). Ordinarily, these assets are the healthiest components of our banks’ balance sheets, even today. Commercial banking is the backbone of our financial system and, if managed prudently, has a much lower risk profile than the securitized investment businesses that are crushing our financial industry.
Commercial banking can be run at very low cost. There are great examples that have reached global scale while sticking to its knits. HSBC, without doubt one of the best run large commercial banks has for long followed the strategic maxim of not straying outside of its core business. The bank continues to thrive. HSBC is one of the few truly global commercial banks. Certainly, it is a saturated market, incurring low rates of growth and little opportunity for expansion. Get used to it!
By taking over failed commercial banks, cum hedge funds, the US taxpayer retains the crown jewels of the system and has a chance to re-establish sound structures and stability at the core of the financial system, all with a budget that is defensible. US commercial banking assets amount to approximately $6 trillion. Assuming government takes ownership of half of these assets, and assuming a 20% write-off (which may be on the high side), total costs amount to no more than $600 billion.
As described in “Eye of the Storm”, whichever way we look at the issue, $50 trillion of total debt, more than 3.5 times GDP, towers over any historical comparison. As an example, merely to shrink back to pre-Great Depression debt levels we would have to take out more than $25 trillion. With an estimated maximum discretionary budget of $5 trillion (excluding debt service payments and recessionary revenue shortfalls) over the next 10 years, the US taxpayer cannot afford anything but an orderly liquidation of these assets.
Given the practices with which this tower of debt was built, we have to assume that a significant portion of it will not survive the looming depression. So far, most of the money spent on this crisis has been taking up more debt, by the taxpayer, to unburden the banks from the worst of these assets. Authorities continue to operate on the assumption that we are in a crisis of confidence and liquidity, while in fact it is very clearly a crisis of over-leverage and mal-investment.
A split up of our banks is doable, it is necessary and it is indeed the only financially viable option. Apart from a reversion to the mean, it will not result in structurally higher interest rates but it will give us a chance to re-establish tested and trusted institutional structures in our financial system, from ground zero, preparing it for the economic pain of the inevitable deleveraging and large scale deflation of asset markets ahead of us. If political will for a tough and professional stance on bank regulation doesn’t materialize, the realities of this crisis will force much more drastic measures further down the line.
The lack of political spine should not be a reason for the Economist to chime in half-baked solutions. If we are to find the will to carry through necessary reforms, our media, in particular such industry heavyweights as the Economist (and others), need to start asking tougher questions. Otherwise we have to start asking some tough questions about their alignment of interests.

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The economy shows signs that it has stopped from falling and markets are up sharply from their low earlier in the year.
Does this mean the crisis is over?
In my last blog “Is this Crisis Over?” you can read about a few reasons why that is highly, highly unlikely. And there is more…
Good friend and brilliant economist Jim Walker has just published an article that brings evidence to the dynamics I am describing in “Eye of the Storm”.
Dr. Jim (as he is lovingly called in the investment community) explains and shows that all that money created by the FED since this crisis started (approximately $2 trillion) has immense trouble finding its way into the real economy but instead sloshes around asset markets, pushing up asset prices.
Despite a more than doubling of base money since early 2008, the US economy has not found any traction and continues to contract. Jim shows that the transmission mechanism is broken. The creation of M1, which is the base of money influenced by central bank action is not even translating into growth in M2, which includes parts of the private sector’s decisions in uses of  money.

Thus, as expected, the Fed is creating a lot of liquidity that does not translate into economic activity.

Loan growth is (and will remain for some time) negative.

One of the key characteristics of this crisis is that it was built on credit. The levels of credit outstanding are unprecedented and unsustainable. The FED continues to believe that creating base money will eventually restart the credit mechanism. I agree, but the cost is very high, in particular for main street. The Fed will have to print a lot of money. Its balance sheet has been expanded to approximately $2.5 trillion. This compares to a total US debt outstanding of $50trillion. All the additional money has been doing was finding a way to become profitable, and no matter what the Fed would like it to do it is not finding its way into the real economy and thus needs to flow into asset markets.
This is evidence that the US economy is not nearly as sound as markets and media are portraying. Markets are celebrating the end of the crisis with taxpayer’s money while hardly any of it is flowing into the real economy. In the meantime still sound businesses and most of all smaller local banks will be watching their loan books deteriorate on falling commercial property and a generally worsening business environment.
These banks and businesses we thought safe and sound because they didn’t engage in all the fancy financial engineering are going to be hit hard in the next round of collapse.
Unfortunately, international dynamics are exacerbating the situation… but this is a subject for another letter.

Feel free to ask any question here.
I will post a weekly blog addressing most and hopefully all of them.