Klaus Kastner replies (adds) to my Mexico City talk

When in Mexico City last week, I argued in favour of financial sector reforms (see previous post) that impose minimum equity limits on the TBTF banks (or SIFIs) while treating very differently (almost motherly) small, local banks, helping establish a rich ecology of local capital recyclers. Klaus Kastner, who has contributed variously in this blog, sent me the following missive. It is worth reading not least because Klaus has had first hand experience of both the TBTF-SIFIs variety of financial institutions and the ‘thousand-flower-banks’ (TFB) variety. 

Admati/Hellwig are appropriately referred to in this speech and I can only recommend to EVERYONE to read their book “The Bankers’ New Clothes”. It should be mandatory reading for every member of parliament and/or government, every regulator, policy maker, etc. in every major country. TBNC’s major argument is that banks can rely far too much on debt instead of equity in financing their assets as evidenced by leverage (total liabilities to equity). Basel-1/2/3 only limit the level of the so-called ‘risk-weighted assets’. To make it worse, banks themselves do the weighting of their risks! This has allowed a bank like Deutsche to accumulate so-called ‘risk-free assets’ up to 5 times the level of risk-weighted assets. Global banks finance their total assets with only 2-3% equity. That represents leverages between 30/50:1. A hedge fund with such leverages would be considered ‘highly leveraged’.

To illustrate: 2% equity means total assets of 100, debt of 98 and equity of 2. If the assets devalue by only 2%, the equity is gone. If the bank had 20% of equity, its total assets of 100 would be financed with 80 debt and 20 equity. If the assets devalue by 2%, 18 equity remain.

The only reason why large banks can do that is because they operate with an implicit (and cost-free) guarantee of the state and that is what needs to be corrected. TBNC recommends:

* Raise equity requirement to 15-20% of TOTAL assets (perhaps even more) through equity increases in nominal as well as percentage terms (that way, banks cannot reduce loans to reach the requirement)

* Immediate stop to dividend payments until the new equity level is reached.

* Banks which cannot reach the new equity requirement over time, either through retained earnings and/or equity increases, should be resolved because they are zombies.

This wouldn’t resolve all problems created by banks. The greatest problem of banks is always managements taking poor risk decisions. Regrettably, that cannot be changed by mandate. Thus, TBNC is a very major step towards a more stable banking sector.

I was particularly touched by the reference to ‘thousand-flower-banks’ (TFB). The first 30 years of my career, I had spent with TBTF-banks; my last 10 years with a TFB-bank. The TBTF-banks saw themselves as an end in itself. Their overriding objective was to maximize ROE, with or without customers in the real economy. The TFB-bank saw itself as a means to an end, namely to transform risks and tenors in the real economy and to enable customers to grow in the process. The ROE came about as a result of this instead of being an objective per se. I link below a paper which I once wrote about a TFB-bank.