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The Right Clearance for the Bumpy Road Ahead

There are many reasons to be scared of the financial system in Europe. The interweaving of sovereign risk and inter-sovereign risk with bank guarantees and the symbiosis in which countries guarantee (implicitly or implicitly) banks which then buy sovereign paper that is not considered a risk asset is enough to make anyone who looks closely pretty queasy. If Portuguese banks fail, what effect does that have on Spanish banks, or on the Europe-wide guarantee facilities? Is anyone even somewhat confident that they know?

However, with all of the reasons to fear a resurgence of the European banking crisis, the manufactured “underfunding” story  is not one of them. According to the Financial Times, “Europe’s biggest banks will have to cut €661bn of assets and generate €47bn of fresh capital over the next five years to comply with forthcoming regulations aimed at reducing the likelihood of another taxpayer funded bailout.”

Those are big numbers, and scary, but … what do they mean? Do they mean that banks are underfunded by that amount?

Well, the numbers only mean that if somehow the Basel III requirement is magically the “right” number. And even then, I am not sure what it means to have the “right” number. If you have trouble driving your Cadillac on a country road, and it leads you to design a car with a higher clearance, how do you know you have the “right” clearance? It sort of depends on the road, doesn’t it? If the road is smooth, then you’ll be too high, but if the road is too rough, your higher clearance might not be high enough. Without seeing the road, all you can do is guess at the trade-off between the cost of the higher clearance, and the benefits of the higher clearance.

And we have no idea what the road ahead looks like in Europe, or anywhere else for that matter. So declaring a certain “clearance” as being the “right” clearance is presumptuous. Sure, we now know that roads can get bumpy even when central banks are trying to smooth them (and in some cases because they are trying to smooth them), so we think we need more clearance…but how much more? Never mind the fact that this isn’t as straightforward as measuring a car’s undercarriage clearance – if a rule can be written into Basel III, it can be engineered around by a bank. (That’s why we didn’t stop at Basel I.)

In general, I am skeptical that the right answer is reached by central banks, or even worse an international committee of central banks such as the BIS, sitting around in a room with a lot of smart economists counting angels on the head of a pin. Not that Jamie Dimon showed great risk acumen in allowing the London Whale to lose six billion bucks, but at least he makes decisions on risk on a regular basis instead of at annual banker meetings where there are presentations on how to tell a CDS from a CMO.

We clearly need to consider how to increase incentives for bank management and shareholders to capitalize banks correctly, where “correctly” means that the shareholders and stakeholders are taking the amount of risk they feel comfortable with, and that there are no unpriced externalities. It is this latter problem that is the issue, of course; a free government guarantee is simply value that bank management seized for themselves. It allows any bank to take more risk than they would if it was their own money. But limiting risk, or raising the “insurance” premium, just raises the clearance of the car. What we need, if banks are large enough to pose systemic risks, is a way to make the costs of poor risk decisions assessable in retrospect rather than in prospect. That is, remove the corporate veil for banking licenses. Require all banks to have a general partner or partnership group which has unlimited liability.

Here is what would happen in such a case. Small banks would have a general partner who would secure liability insurance (possibly paid for by the bank shareholders). Larger banks would find it more difficult and expensive to secure that insurance in amounts that completely covered the possible losses for the general partner, which would mean that the biggest banks would likely choose to break into smaller banks. And what is wrong with that? One of the solutions that has been put forth is to have banks sell off assets. Splintering into a number of smaller banks is the same as selling off all of the assets.

And then, you wouldn’t need implicit or explicit government guarantees (although deposit insurance might best be provided by, or backstopped by, a government entity). There’s already someone to go to in order to cover the losses: the general partner, or the insurer, or the reinsurer. Together with derivative clearing arrangements, a system built from smaller and redundant parts would likely be much more resilient than one built with just a few critical “TBTF” parts.

  1. August 12, 2013 at 4:09 pm

    I hate to burst your bubble but your proposed solution would have some quite negative consequences for corporate America and there would be a dramatic outcry on their part. Remember, the primary purpose of a bank is to take deposits and make loans, all the other stuff is in lieu of loans to clients. But when it comes to lending to big companies, the loans get pretty big, with revolving credit facilities in excess of $10 billion not that uncommon. Now given the current restrictions with regard to how much a bank can lend to a single credit are based on the bank’s size, by shrinking all the banks, a $10 billion revolver would have to have something like 50-80 banks in it to be funded as opposed to the current 15-25. And I promise you that companies do NOT want to have to deal with that many banks. They are already unhappy at 15 banks. Unless banking regulations were changed to allow loans of a larger percentage of bank capital, your idea would result in some very significant, and likely somewhat destabilizing, changes to the banking system.
    And a change like the latter would result in highly concentrated risk at some banks, also a problem. The biggest benefit I see from the fact that there are a relatively small number of very large banks is that they have the capacity to lend significant amounts of money to corporate clients while not having any single loan dominate their portfolio.
    Shrinking the banks would result in a great many changes, of which I am certain not all would be positive for the system or individuals.

    Just a thought. I do like the idea of more capital, I am just not certain that breaking up the banks will have as many positive consequences and almost certainly it will have many negative ones on other parties.

    • August 12, 2013 at 6:16 pm

      I appreciate the counterpoint, but I can respond to it very simply: if this is a problem, then surely there would be demand to create an intermediary that bundled loans to big corporates. Why does Caterpillar need to know which banks are lending to them? Why not face LendingCorp, which is simply an SPV that faces 80 banks and 1 corporate? Come on, that’s Financial Engineering 101.

      But I would also say that if a bank needs $10bln, there are alternative to the bank loan market. The only reasons they go to bank lending is that (a) it’s no-doc compared to the Reg D stuff, (b) underpriced funds (apparently, since no one is paying for the destabilizing), or (c) they need a roller-coaster amount. If it’s (a) or (b), then issue a fricking bond, if you need $10bln. If you need it as a revolver, then as I said just create a non-bank pass-thru facility and the problem is solved.

      I see your point; I just don’t think it’s worth risking the entire financial architecture so that the financial veep doesn’t need to work hard to arrange his revolver. And, evidently, we’ve been risking the entire financial architecture.

      But maybe I just have personal issues about big banks. 🙂

  2. August 15, 2013 at 3:02 pm

    the thing that concerns me about your solution is the creation of an SPV for this. after all, SPV’s represent thinly capitalized entities that exist to get around rules. and it strikes me that the purpose of your proposal is to change the rules, not encourage the workaround. if banks were smaller, then no one institution would be systemic with regard to risk, but history has shown that creating an SPV is starting down the slippery slope already.

    • August 15, 2013 at 3:54 pm

      Hmm, so it’s better to stay on the old path that we KNOW doesn’t work, than to try a new one that might have a slippery-slope branch? I don’t know about that. But in this case, the SPV wouldn’t be thinly-capitalized. It would be essentially NOT capitalized, as it is just a conduit for helping the poor beleaguered CIO deal with one set of documents instead of 50-80. But each bank owns 1/50th of the structure pari passu with the others, and it would be consolidated on-balance-sheet just like any other loan. So it wouldn’t look any different to the bank…the structure is just cosmetic, not a way to channel risk or increase leverage like SPVs have been abused for in the past.

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