“I don’t really understand why there needs to be so much tension about this. The country is facing the worst economy since the Great Depression. If the financial system collapses, it will take every one of you down.”
~ Ben Bernanke, Fall 2008
It’s been well over 5 years now since the most powerful bankers of the Western world, in the wood-paneled boardroom of the Federal Reserve Bank of New York in downtown Manhattan, convened to debate over the fate of Lehman Brothers. Henry Paulson, then the Head of the US Treasury, had called the meeting. Today, we all clearly remember what happened.
Barclays was interested in the takeover of Lehman. However, Hank Paulson was not willing to afford any kinds of financial guarantees and the British financial authorities did not allow Barclays to proceed without those guarantees. Monday, September 15th, 2008, came along and Lehman Brothers went into Chapter 11.
Soon after, the world’s financial system – and with it the global economy – went into a free fall. What followed – and continues to this day – was what will presumably go down in history as the greatest internationally concerted “rescue plan”, the biggest monetary and fiscal intervention of all times.
Today, years later, we find ourselves wondering if anything has been gained? Is the financial system any safer than it was before 2008? Or, is the system just as fragile and loaded with risk as it ever was?
Simon Johnson, economic professor at MIT and former chief economist of the IMF, says “No”, it isn’t safer at all. In a recent interview with Swiss journalist Mark Dittli, Mr. Johnson stated that the incentive systems of banks had hardly changed and that at the regulatory level, hardly anything has been achieved since 2008.
There has been a regulatory flood since 2008. We’ve seen the likes of Dodd-Frank, FATCA, MIFID, and AIFMD. The Europeans are now feverishly pushing for an international standard of AIE, or Automatic Information Exchange.
However, these regulatory beauties largely target the taxpayer and the smaller financial advisors and institutions. None of these regulations really attack the root of the problem: money that is too cheap, i.e. increasingly low interest rates that are out of sync with true risk, and too-big-to-fail banks that benefit from access to these very low interest rates via their implicit state guarantees. The big banks were already regulated heavily before 2008. It did not help. And now, the additional muck of new grand regulations is helping the big banks increasingly crowd out the smaller players.
But, what about Basel III? Yes, the Basel III capital standards were defined and put in place to address the issue of too-big-to-fail banks that are not sufficiently capitalized. Presumably, higher capital requirements, i.e. more conservative leverage ratios, were defined to make such banks more resistant to a financial crisis.
However, the bankers’ lobby is probably the most powerful worldwide and Basel III turned out to be nothing more than mere window dressing. Today, the big banks are not really capitalized any better than in 2008. They don’t have enough equity in their balance sheets. Basel III allows them to use a “risk-adjusted valuation” of assets which results in capital ratios that “look too good”.
Regulations based on logical fallacies
The term “risk-adjusted valuation” in essence means that the assets and liabilities of a bank’s balance sheet are weighted according to their risk. The rules of weighting and valuation are complex and, as often is the case, more of an art than a precise function. Last fall, these rules were reviewed and presented thoroughly in a speech by Thomas Hoenig, FDIC Vice Chairman and former President of the Federal Reserve Bank of Kansas City.
Mr. Hoenig started his speech as follows: “Aristotle is credited with being the first philosopher to systematically study logical fallacies, which he defined as arguments that appear valid but, in fact, are not. I call them well-intended illusions.
“One such illusion of precision is the Basel capital standards in which world supervisory authorities rely principally on a Tier 1 capital ratio to judge the adequacy of bank capital and balance sheet strength. For the largest of these firms, each dollar of risk-weighted assets is funded with 12 to 15 cents in equity capital, projecting the illusion that these firms are well capitalized. The reality is that each dollar of their total assets is funded with far less equity capital, leaving open the matter of how well capitalized they might be.”
To drive home his critical views on risk weighting, Hoenig used some powerful charts.
For example, as portrayed in the following chart, he made the point that in a long-term context, the current capitalization of banks is at an historic low. The chart shows the average equity as a percent of assets for U.S. commercial banks from 1840 to 1993. In the 19th century, it appears that capitalization ranged from 30% to 40%.
After the creation of the Federal Reserve as a lender of last resort for the banks, the ratio continuously retreated as banks would increasingly depend on state support in the case of an emergency. After the World War II, a capital ratio of about 10% became the norm.
Then, with further deregulation starting in the early eighties, lower and lower “risk-free” interest, and the “creativity” of bankers, the ratio went even lower in the 90’s.
It is important to note that Chart 5 can be misleading though. It portrays the average of all commercial banks. Many smaller, regional commercial banks to this day still have higher capital ratios, which of course lifts the average ratio. Giant banks like Citibank or J.P. Morgan Chase have less than 4% and had less than 3% prior to the Lehman debacle.
Bankers, of course, argue that risk-adjusted weighting of assets gives you a more precise picture of the “true risk” on the balance sheet. Can we trust this “more precise picture”? To this, Thomas Hoenig gives a resounding “No”.
Common sense would tell us that a bank with higher capitalization will have less risk of defaulting. And, we would logically expect investors to afford a bank with higher capitalization a higher valuation premium.
However, in his speech and via a series of charts, Hoenig is able to show how common sense and economic logic is basically removed by Basel III-style risk-weighting rules.
Risk-weighted ratios are like camouflage
The following charts and discussion are going to get a bit technical. In essence, they depict the statistical relationship, the correlation, of two variables shown on the axes of the graphs.
In the left chart, the horizontal axis is the “leverage ratio”, the ratio of Tier 1 equity as a percentage of total assets, without risk-weighting. The vertical axis depicts the price-to-book ratio, i.e. the premium that financial markets afford the price of a bank’s stock. The result appears logical: the graph shows a positive correlation of a bank’s balance sheet strength (leverage ratio) and its price-to-book ratio.
In other words, a bank with a higher capitalization will tend to be seen as “more valuable” and given a higher price premium. Therefore, bank managers should actually have a fundamental self-interest of increasing the capital of their banks. Right? Well, let’s look at the other chart, the one on the right.
It depicts the “Tier 1 Capital Ratio”, i.e. the capital ratio that is based on risk-weighted numbers. Interestingly, we can only recognize a minimal, if any, correlation of capitalization and price-to-book-ratio. Risk-weighting removes the logic of “safety-premiums” and implicitly removes any incentive to raise capital.
The message in the following charts is even more pronounced. In these charts, the correlation of a bank’s risk to default (one-year estimated default frequency) is compared with its capitalization, with the one on the left again being without risk weighting, the one on the right with. In looking at the left chart, derived from data without risk weighting, common sense logic again appears to exist. There’s a negative correlation between a bank’s capitalization and its default probability. In other words, the better a bank is capitalized, the lower its risk to default is.
We would all agree that a bank that has a lot of equity and, vice versa, little debt exposures should be expected to be the safer bank. Right? Well, again, the second chart on the right, tells a different story. In this case, there is practically a zero correlation!?!?
The graph on the right tells us the following: whether a bank has a Tier 1 Capital Ratio (a risk-weighted equity to assets ratio) of 10% or 20% has no inference to whether that bank has a higher risk to default.
It also implies that a bank with a Tier 1 Capital Ratio of 20% can go into insolvency as easily as a bank with a Tier 1 Capital Ratio of 10%. That was the case with Lehman Brothers. They had a Tier 1 Capital Ratio of 11.6% the night before the announced bankruptcy.
To put it more bluntly, these Tier 1 Capital Ratios are useless…they don’t mean anything! Or to put it in Hoenigs words: “While such findings are not conclusive, they suggest strongly that investors, when deciding where to place their money, rely upon the information provided by the leverage ratio”. If you believe the official spin that “banks are much safer and highly capitalized today”, you are being fooled by just one more accounting shenanigan and set of bogus numbers.
The rules of Basel III were constructed by bankers, for bankers. The incentive system is still skewed, leaning toward less capital, greater size, and more state-subsidized, too-big-to-fail cheap money. Regulators, politicians, the media and the public have accepted the farcical solutions served to us. We have thereby accepted the reality that 2008 can, and will, happen again.
In conclusion, if you’re interested in wealth preservation, you need to ask the following questions: with ever-rising sovereign debt, a continuously growing block of derivatives and too-big-to-fail banks that are back to the game of pre-subprime, should I trust the official numbers and recovery storyline? What can I do to protect myself from a repeat of 2008 and the certainty of heavy-handed interventions that will follow?
BFI Wealth Management (International) is an independent wealth management and investment advisory firm with offices in Switzerland. BFI specializes in providing their upscale international clientele with a single point of contact for an array of multi-jurisdictional wealth services and solutions. BFI Wealth Management is a subsidiary of BFI Capital Group, a company with 20 years experience in offering a unique array of premium risk and wealth management services to private and institutional clients.
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