The Fourteenth Banker Blog

December 6, 2010

Bank Capital Discussion

Filed under: Running Commentary — thefourteenthbanker @ 12:49 PM

Simon Johnson has an excellent post on Baseline Scenario regarding the debate about bank capital. This debate is often in the background because there is a prevailing assumption that  super high leverage is and should be the norm for financial services. Why?

The debate in the last week became higher profile as a result of a piece on Jamie Dimon in the New York Times Magazine. Check out that cover. In the piece, Dimon is framed as a competent and reasonable man. He sounds reasonable. What he says is reasonable from within the paradigm he lives.

An example:

Dimon does not dispute that mortgage lenders and investment banks deserve a lot of the blame. But regulatory lapses and excess leverage throughout the system, he says, contributed as well. What gets him riled is his sense that Washington is captive to a binary, us-against-them environment in which bankers are cast as villains. Perhaps naïvely, he was disappointed that political concerns played a large role in shaping the legislation. (An example is that Dodd-Frank limited bank investment in hedge funds, even though the latter were peripheral to the crisis.) In contrast, Dimon admires the approach of the members of the Basel Committee, the international regulators who are imposing heightened capital requirements, because they are asking the questions that, in theory, bankers ask of themselves: how much capital do banks need to withstand the inevitable downturn, and what is an acceptable level of risk?

Basel is a very minor tweak in capital requirements. Simon Johnson’s take?

There is one problem, however. Basel may have asked the right question, but it did not come up with the right answers, mainly because it allows banks to remain dangerously leveraged, setting equity requirements way too low.

My beef is with the way the argument is conducted. This has become typical in our media bite culture. Make a quick assertion, repeat it endlessly, and people buy it. Here is the argument bankers are making about capital, in Simon’s words:

Bankers tell us that they must be allowed to maintain high leverage because this is part of the business of banking. They assert that economies will suffer if they are made to fund more of their investments with equity, there will be credit crunches, terrible things will happen. We clearly must examine these statements carefully before agreeing.

To summarize Simon’s point, he is saying that high leverage is a result of a combination of government policy that promotes leverage in a variety of ways, such as regulation, the tax code, implicit guarantees for TBTF institutions, and private interests that benefit from leverage because of the large profits and compensation it can bring to bankers and shareholders. I agree with Simon on this. The leverage that exists in the system is natural because of the assumptions that all of us are operating under. If you throw out the assumption that high leverage is the norm, is necessary for the economy, and that reducing leverage will cause a crisis, than you are no longer bound by the logical end point of those assumptions, which is to not rock the boat. You can ask, “why”? And you can realize that there are alternatives.

The existing banking system will persuasively argue its book every time. That does not mean anyone else has to buy it. If there is to be a banking model that is less leveraged and produces less fragility for the system, society has to choose it.



  1. Bank leverage is a perpetual opinion issue. A century ago, state banks in particular, held up to 25 % of deposits in reserve. That is in Specie too. How do you judge the adequacy of allocations of bank Equity to any given transaction? Bank Equity is a proportion of total bank assets represented by shareholder interest in the bank. What the shareholder risks. Here is a bombshell notice I received yesterday from bank headlining my checking account statement.

    Notice of Changes In Temporary FDIC Insurance Coverage for Transaction Accounts

    ” All funds in a “noninterest-bearing transaction account” are insured in full by the Federal DEposit Insurance Corporation from December 31, 2010,through DEcember 31, 2012. This temp[orary unlimited coverage is in addition to,and separate from,the coverage of at least $250,000 available to depositors under the FDIC’s general deposit insurance rules.

    The term “noninterest-bearing transaction account” includes a traditional checking account or demand deposit account on which the insured depositary institution pays no interest. It does not include other accounts ,such as traditional checking or demand deposit accounts that may earn interest,NOW accounts,money market deposit accounts,and Interest on Lawyers Trust Accounts (” IOLTAs”. For more information about temporary FDIC insurance coverage of transactions accounts,visit”

    Talk about doubletalk.

    Comment by Jerry J — December 7, 2010 @ 12:12 PM | Reply

    • Yes it is. Going into the financial crisis some TBTF banks has Tangible Common Equity as low as about 4%. I think it is safe to say that is too low. The deposit insurance issue you raise is part of the issue. Depositors are protected by FDIC, in come cases without limit, until such program expires. Bondholders are protected by Treasury and Fed bailouts. Stockholders and managers may as well roll the dice. Heads I win, tails you (taxpayers) lose.

      Comment by thefourteenthbanker — December 7, 2010 @ 6:03 PM | Reply

  2. At the end of the day banks loan to term and there is no substitute for a sound loan repayable from sound debtors. No bank, as opposed to a merchant, can own loans marked to daily market and to term at the same time. As to market value, only the shortest term loans might coincide with a market. If loans are measured by what others will pay now for holding to term , then there is a real consideration for including call features on a loan if there are market losses. That simply would be disaster. Loan qualifications too would be solely at the discretion of the loan officer as agent for the bank. No Community Reinvestment Act. Until quite recently in the scheme of things banks were general partnerships. If the bank went down, every partner went with it.

    How would it even be possible to introduce capital leverage limits when the enterprise is both a merchant and a banker covered by an umbrella Bank Holding Company. Under the present ” conglomerate” actual holdings of the big time BHC any rules could be circumvented, over time, by people like me. The challenge would be awesome… hence rewarding in just cracking the rule for the sake of cracking it. Rules are made to be broken because if there were no offending behaviour there would be no need for the rule. That is a challenge the adventuresome and imaginative will always undertake. Besides, who would have made the rules but crooks themselves under the prevalent present beliefs? The do gooder would be misguided from being unable to entertain a personally crooked mind. Why did FDR pick Joe Kennedy to be the first head of the SEC?

    Make bank shares assessable as they once were and at higher multiples of a fairly high par value? Buying the shares carry potential assessments for any time in the past.

    There is no way to sugar coat and insulate consequences of losing depositor funds. Of course, what I discuss here would require high distributed yields to shareholders. That means renting money should be at a high rent. It is impossible to impose consequences and shareholder responsibility for employee conduct and have low interest rates at the same time. I can see no way out of this conundrum except very difficult standards for loaning money and that is absolutely impossible in financing consumption.

    The present banking system may only fail if finances consumption too heavily. The present real economy fails without cheap finance.

    Comment by Jerry J — December 7, 2010 @ 9:32 PM | Reply

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