More Evidence of Undercapitalization/Insolvency of Major Banks

More Evidence of Undercapitalization/Insolvency of Major Banks

Posted: 20 Jan 2011 09:05 PM PST

Even as we and other commentators have noted the underlying weakness of major bank balance sheets, which have been propped up by asset-price-flattering super low interest rates and regulatory forbearance, we still witness the unseemly spectacle of major banks keen to leverage up again. The current ruse is raising dividends to shareholders, a move the Fed seems likely to approve. Anat Admati reminded us in the Financial Times on Wednesday that we are about to repeat the mistakes of the crisis:

Paying dividends helps banks maintain excessive leverage. A typical bank funds over 95 per cent of its investments with debt and less than 5 per cent with equity. A small drop in asset values can lead to distress and possible insolvency. We have seen that furious “deleveraging” by any highly leveraged and interconnected bank can start a crisis…

The Basel III reforms agreed last year set minimum bank equity between 4.5 per cent and 7 per cent of “risk-weighted assets”, which are significantly smaller than total assets for most banks. Triple A-rated assets require little or no equity capital. The system of risk weights established by Basel II, which distorts banks’ investments towards favourably treated assets, was mostly maintained. Under Basel III, the ratio of equity to total assets can be as low as 3 per cent.

These equity requirements are dangerously low. Significantly increasing banks’ equity funding would provide many benefits to the economy, at little social cost.

Our Richard Smith has provided a series of posts analyzing the many shortcomings of Basel III (see here, here, here and here); below is his drive-by shooting:

Here are my main gripes:

Valuation: the capital ratios mean nothing if the assets are overvalued. Waldman is always going on about this. It ends up as quite a radical critique: capital ratios without valuation reform = cart before horse.

Accounting: there is still no harmonization of accounting practices on all the shadow banking apparatus: for instance, special purpose vehicles, derivative netting and repos. Actually, of course, when you come across things like Repo 105, or BoA’s quarter end balance sheet manipulations, there don’t seem to be any relevant reputable accounting practices at all; even if you think Lehman’s liquidity pool probably is an outlier, some of this stuff really, really needs fixing. And do we think that under Basel III there will be more accounting dodges that will cross the line from ‘asset sweating’ to ‘accounting manipulation’?  Not Basel III’s fault, but I rather think we do expect exactly that.

Regulatory risk weightings are still a mess, with the ratings agencies still ensconced as the arbiters of credit quality.

Then of course there is shadow banking, which Basel III largely dances around. One particularly glaring example is the whole custody/client money/asset segregation/rehypothecation/title mess in London. There’s not a peep, burble or whisper here in the UK about the sort of legal reforms (somewhat in the manner of the US’s 1934 Securities Act, perhaps, plus a UK version of SIPC) that would sort this out. Recent Lehman-related rulings on Client Money actually mess the situation up even more. Of course, our obligingly vague 17th century line on “who owns what” works very capital-efficiently for Prime Brokerages. Which is a big part of why Mayfair now houses a $4Trillion shadow banking system. Push from Basel III would have helped get more of a grip.

I have nothing to say about enforcement; it’s been such a long time since I’ve seen any that I’ve forgotten what it is.

London Banker takes an equally dim view (”More on the lunacy of the Basel Accords”), and in particular, scotches the asset risk weightings:

I was looking at the preferred asset classes under the Basel Accords…and realised that every single asset class that is given less than a 100 percent credit risk weighting is now tainted by widespread default, scandals or bailouts.

The credit risk weightings mean that instead of reserving the standard 8 percent of capital in respect of a debt, the bank can cut that by the weighting applied to the asset class. Effectively, the reduction in credit risk weighting operates as a powerful subsidy to the borrowers and equally powerful incentive to over-leveraging the lenders.

But we don’t need to wait for Basel III to come into effect to provide cover for continued bank undercapitialization, which is tantamount to undue risktaking sure to be eventually eaten by taxpayers. We’ve pointed out that properly valuing second mortgage and commercial real estate exposures would put a serious dent in the reported equity of the four biggest banks. They have additional, yet to be determined liability as servicers and trustees of residential mortgage backed securities. The big European banks went into the crisis with even lower capital levels than their US peers and are widely considered to have done less to rebuild equity. And that is before factoring in their exposures to the evolving sovereign debt crisis.

Gillian Tett of the Financial Times today points to yet another time bomb which combined with the other factors listed above would wipe out the stated capital of major banks:

For one thing, this saga highlights something banks have long preferred to conceal: namely the wider level of under-collateralisation in the OTC derivatives market. Last year, Manmohan Singh, an economist at the International Monetary Fund, calculated, for example, that if market participants posted sufficient collateral to cover all OTC deals properly, they would need an extra $2,000bn (or about $100bn per big dealer). The TABB consultancy has reached similar conclusions*. And while banks dispute this data, these numbers are sobering; particularly since OTC business is now moving on to clearing houses – where collateral will be mandatory.

Those undercollateralized OTC derivatives are certain to consist largely, if not entirely, of credit default swaps, a product we have argued here and in ECONNED serves no legitimate social purpose and needs to be strangled over time (there are reasons that simply banning them and letting existing exposures run off would lead to dislocations). They are certain to continue to be undercapitalized at a clearinghouse, for adequate margining of CDS renders the product uneconomic. Thus moving them over to a clearinghouse is effectively another bailout, shifting risk from banks via creating another TBTF entity.

Einstein once said, “The definition of insanity is doing the same thing over and over again and expecting different results.” But the producers and top brass of the major financial firms found blowing up the global economy to be a hugely profitable exercise. 2009 bonuses were even richer than in 2007, and industry concentration increased, meaning their hold on power is even more secure than before. So for them, this conduct is completely predictable. I find it difficult to believe that regulators do not also see what is really at work, which means that one can only conclude that they are not insane but are either in denial or deeply corrupt.