12/20/2018 Understanding Bank Capital: A Primer — Money, Banking and Financial Markets

Understanding Bank Capital: A Primer

February 12, 2018

“It is clear that the banks have too much capital.” Jamie Dimon (CEO, JPMorgan),
Annual Le er to Shareholders, April 4, 2017.

“If JPMorgan really had demand for additional loans from creditworthy
borrowers, why did it turn those customers away and instead choose to buy
back its stock?” Neel Kashkari (President, Federal Reserve Bank of
Minneapolis), Jamie Dimon’s Shareholder (Advocacy) Le er, April 6, 2017

Over the past 40 years, U.S. capital markets have grown much faster than
banks, so that banks’ share of credit to the private nonfinancial sector has
dropped from 55% to 34% (see BIS statistics here). Nevertheless, banks
remain a critical part of the financial system. They operate the payments
system, supply credit, and serve as agents and catalysts for a wide range of
other financial transactions. As a result, their well-being remains a key
concern. A resilient banking system is, above all, one that has sufficient
capital to weather the loan defaults and declines in asset values that will
inevitably come.

In this primer, we explain the nature of bank capital, highlighting its role as a
form of self-insurance providing both a buffer against unforeseen losses and an
incentive to manage risk-taking. We describe some of the challenges in
measuring capital and briefly discuss a range of approaches for se ing capital
requirements. While we do not know the optimal level of capital that banks (or
other intermediaries) should be required to hold, we suggest a practical
approach for se ing requirements that would promote the safety of the
financial system without diminishing its efficiency.

What is bank capital? There are several consistent definitions of a bank’s

capital (or, equivalently, its net worth). First, capital is the accounting residual
that remains after subtracting a bank’s fixed liabilities from its assets. Second,
it is what is owed to the banks’ owners—its shareholders—after liquidating
all the assets at their accounting value. Third, it is the buffer that separates the
bank from insolvency: the point at which its liabilities exceed the value of
assets.

The following figure shows the balance sheet of a simple bank that finances
its assets (composed of cash, securities, loans, and other instruments) with
deposits and other debts, as well as the equity and retained earnings that
constitute its net worth. The proportions shown correspond to the average
shares of these components in the U.S. commercial banking system at the end
of 2017 (see here). In this example, the bank’s capital is 11.3% of assets,
corresponding to the gap between total assets (100%) on the one hand and
the combination of deposits and other fixed liabilities (88.7%) on the other.
This fraction is also known as the bank’s leverage ratio: the ratio of capital to
assets. For comparison, the leverage ratio a decade earlier (amid the financial
crisis) was 7.2% (see data here).

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A Simple Bank: Percent Shares of Assets and of Liabilities and Net Worth
(Capital)

Source: FRED (based on Federal Reserve Board H.8 for U.S. Commercial Banks, December 2017).

Importantly, capital is a source of funds that the bank uses to acquire assets.
This means that, if a bank were to issue an extra dollar worth of equity or
retain an additional dollar of earnings, it can use this to increase its holding
of cash, securities, loans, or any other asset. When the bank finances
additional assets with capital, its leverage ratio rises.

Banks (and many other financial intermediaries) issue a far larger proportion
of debt (relative to equity) than nonfinancial firms. Recent data show that
nonfinancial firms have between $0.80 and $1.50 worth of debt liabilities for
each dollar of equity (see here and here). By contrast, as we can see from the
figure above, the average U.S. commercial bank has a debt-to-equity ratio of
roughly 8. This reliance on debt boosts both the expected return on and the
riskiness of bank equity, and makes banks vulnerable to insolvency.

In addition to their balance-sheet risks, banks also tend to have a variety of

large off-balance-sheet exposures. The most prominent are derivatives
positions, which have gross notional value in the trillions of dollars for the
biggest global banks, and credit commitments (for a fee), which appear on
the balance sheet only after the borrower exercises their option to draw down
the loan. As a result, simple balance sheet information understates the
riskiness of banks, especially large ones.

Role of bank capital. Bank capital acts as self-insurance, providing a buffer

against insolvency and, so long as it is sufficiently positive, giving bank
management an incentive to manage risk prudently. Automobile insurance is
designed to create a similar incentive: auto owners bear part of the risk of
accidents through deductibles and co-pays, which also motivate them to keep
their vehicles road-ready and to drive safely.

When capital is too low relative to assets, however, bank managers have an
incentive to take risk. The reason is straightforward. Shareholders’ downside
risk is limited to their initial investment, while their upside opportunity is
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unlimited. As capital deteriorates, potential further losses shrink, but possible

gains do not. Because shareholders face a one-way bet, they will encourage
bank managers to gamble for redemption. This problem goes away as the level
of capital rises. That is, when shareholders have more skin in the game, they
will be exposed to greater losses and will encourage the bank managers to act
more prudently. (See Myers for a discussion of this debt overhang problem).

The role of self-insurance is most important for those banks that are too big to
fail (TBTF). As we have discussed in a recent post, governments cannot
credibly promise to avoid future bailouts if the alternative is economic
disaster (see the primer on time consistency). Consequently, anticipating a
bailout, TBTF banks have an incentive to take risks that will spill over to the
financial system as a whole. Making TBTF banks resilient through increased
self-insurance both ensures their shareholders will bear losses and prompts
these firms to internalize the spillovers that otherwise would occur.

Finally, a banking system that is short of capital can damage the broader
economy in three ways. First, an undercapitalized bank is less able to supply
credit to healthy borrowers. Second, weak banks may evergreen loans to
zombie firms, adding unpaid interest to a loan’s principal to avoid taking
losses and further undermining their already weak capital position (see here).
Finally, in the presence of a widespread capital shortfall, the system is more
vulnerable to widespread panic, reflecting fears that some banks may be
lemons (see the primer on adverse selection).

Measuring bank capital and exposures. The definition of bank capital makes
it seem deceptively simple to measure: just subtract liabilities from assets.
Unfortunately, it is often very difficult to measure the value of assets. (And
even more difficult to figure out how to treat off-balance sheet exposures.)

At any moment in time, assets are worth what buyers will pay for them.
Determining the value of a liquid instrument, like a U.S. Treasury bond, is
easy. However, most securities—like corporate, municipal, and emerging
market bonds, are significantly less liquid than Treasuries (see here). And
since most bank loans, which represent more than one-half of U.S.
commercial bank assets, do not trade at all, no one knows their market price.
Finally, in periods of financial strain, even active markets can freeze, making
the value of a bank’s assets even more difficult to value.

Aside from liquidity, the value of an asset may depend on the solvency of the
bank. At one extreme, some intangible assets only have value when the bank
is a going concern. For example, when one bank acquires another, the excess
of the purchase price over the accounting value of the target becomes goodwill
on the balance sheet of the newly merged entity. Another example is deferred
tax assets (DTAs). A bank is allowed to use past losses to reduce future tax
payments, assuming that they become profitable and would otherwise owe
taxes. Neither goodwill nor DTAs typically have value if the bank fails.

We should emphasize that this is not a small ma er. As of mid-2017, for the
eight U.S. global systemically important banks (G-SIBs), goodwill plus DTAs

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corresponded to 26% of tangible equity (see here). Five years, earlier, that
ratio was 39% (including a whopping 48% for Bank of America).

The presence of intangibles means that the book value of capital may tell us
relatively li le about the ability of a bank’s balance sheet to absorb
unforeseen losses on its assets (on- and off-balance sheet) without becoming
insolvent. For that purpose, regulators often exclude things like DTAs from
their computation of net worth.

In addition to capital, we also need to compute the assets or exposures

against which net worth provides a buffer. Derivatives and accounting
conventions complicate this calculation. The five largest U.S. banks held more
than $200 trillion of gross notional value as of end-2015 (see here). To take
account of these off-balance-sheet exposures, regulators apply credit
conversion factors (CCFs) to translate derivatives exposures into asset
equivalents that they then use to calculate capital ratios. But, accounting
frameworks differ significantly: under U.S. GAAP, a bank may use collateral
it receives from a counterparty to offset (or net) a derivatives exposure.
Under International Financing Reporting Standards (IFRS), which apply
outside the United States, it cannot.

Doubts about GAAP ne ing—which generously assumes that collateral is of

high quality, has not been re-lent, and can always be sold—lead us to prefer
IFRS measures of capital adequacy. For the largest banks that dominate
global derivatives trading, the difference is enormous. As the chart below
shows, for the U.S. G-SIBs, in 2017 the leverage ratio was 8.24% under GAAP,
but only 6.62% under IFRS. Back in 2012, the levels were lower and the
disparity even larger: 6.17% vs. 3.88%. Put differently, under IFRS in 2012, the
effective debt of the biggest banks was nearly 25 times their capital. That ratio
is still greater than 15.

U.S. G-SIB Capital-to-Asset Ratios (Percent): GAAP, IFRS, and Basel Risk-
Weighted Assets

Note: The 2012 and 2017 measures for Basel Risk-Weighted Assets were calculated under Basel I and Basel III
standards, respectively. Source: FDIC Global Capital Index (2Q 2012 and 2Q 2017).

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Furthermore, these exposure measures ignore the riskiness of the assets

themselves. A bank that holds Treasury debt will be significantly less risky
than one that makes illiquid loans with a comparable duration. For these
reasons, regulators also measure risk-weighted assets. The risk weights range
from zero (for Treasury debt) to more than 100% (for the riskiest loans).

Using risk-weighted measures, capital ratios appear higher (see chart above).
But this ignores the ability of banks to “game” the risk-weighted measures by
concentrating their holdings in assets with understated risk weights
(including, in some cases, sovereign debt). Moreover, hypothetical portfolio
exercises reveal that banks’ internal models generate vastly different
measures of risk-weighted assets for the same portfolio. For these reasons,
supervisors view leverage ratios as a useful supplement to those that are risk
weighted.

Capital requirements. Minimum capital requirements are the leading

regulatory tool for ensuring resilience of the banks (and bank-like
intermediaries). In addition, regulators use stress tests to limit concealed risk
and to measure the capital adequacy of banks in scenarios where asset prices
are assumed to decline dramatically, markets cease to operate and funding
dries up. The combination of higher capital requirements and stringent stress
tests has led to a sharp rise in banking system capital in the decade since the
financial crisis. But how much capital is enough?

The fundamental theorem of corporate finance—the Modigliani-Miller (MM)

theorem—states that, under a specific set of circumstances, firms (including
banks) will be indifferent between debt and equity finance. The MM
assumptions are clearly violated. If we let the banks choose, they typically
minimize reliance on equity funding, which they perceive as expensive (see
the opening quote from Jamie Dimon and the reply from Neel Kashkari).

The question of how to set capital requirements depends in part on the

factors causing the MM violations that lead banks to prefer debt to equity.
The candidates are numerous, ranging from distortionary government debt
subsidies (in the form of explicit and implicit guarantees) to information
asymmetries that make collateralized short-term debt finance relatively
a ractive. Raising capital requirements will raise a bank’s private costs. But, to
the extent that higher capital requirements reduce the distortions from
subsidies and compensate for banks’ ability to conceal risk off balance sheet,
social cost will decline.

MM is not the end of the story. As requirements rise on banks, the

opportunity to reduce private costs will encourage a shift of risk-taking to
non-banks—beyond the regulatory perimeter. One solution to this is to focus
regulation on the economic function rather than the legal form of the
intermediary (see here). Absent such a system, there will be a point where
higher capital requirements, while making banks more resilient, will make
the financial system less safe as a result of risk-shifting.

Accordingly, there is a range of views about the appropriate level for capital
requirements. At the top end, proponents of narrow banking call for all risky
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assets to be 100% financed by equity. Admati and Hellwig advocate a

leverage ratio of 20% to 30%. The Minneapolis Plan to End Too Big to Fail
would set the number in the 15% to 24% range, while Dagher et al argue that
15% would be sufficient to absorb the losses in 90% of past OECD banking
crises. Notably, all these proposals far exceed current capital requirements—
which are between 3% and 5%—as well as current leverage ratios (computed
using a variant of IFRS) of the 30 largest global banks. The la er range from
3.4% to 7.6% (see G-SIBs "Fully phased-in" column of Annex Table C.35 here).
In contrast, the Treasury argued in June 2017 that capital requirements for the
largest U.S. banks should be “recalibrated” in cases where they exceed
international standards.

We do not know the optimal capital ratio for banks. But, in contrast with the
Treasury (and with Jamie Dimon), we believe that current capital
requirements are not high enough. Our practical suggestion is to raise capital
requirements gradually until we observe either a reduced supply of bank
credit or a shift of risk-taking to de facto banks. Absent these negative side
effects, more bank capital means a safer financial system without loss of
efficiency.

Permalink
Tags: Assets, Liabilities, Net worth, Capital, Capital adequacy, Capital
requirements, Loss-absorbing capacity, Exposure, Leverage ratio, Debt-equity
ratio, Self-insurance, Incentives, Solvency, Liquidity, Risk-weighted assets,
Derivatives, Balance sheet, Off-balance sheet, Debt overhang, Gamble for
redemption, Skin in the game, Too big to fail, Time consistency, Adverse
selection, Goodwill, Intangible capital, Deferred tax assets, Credit conversion
factor, US GAAP, IFRS, Hypothetical portfolio exercise, Modigliani-Miller
theorem, Minneapolis Plan, Narrow banking, De factor bank, Credit supply,
De facto bank, Primer
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