Saturday, July 16, 2011

How do you feel about a 30% capital ratio?

I try to keep myself abreast of the significant changes within the banking industry so I can perform research, form a reasonable opinion, and advise my clients. But some industry luminaries are throwing out some far reaching opinions that I think need refuting.

Take Simon Johnson, former chief economist of the International Monetary Fund, co-author of 13 Bankers, and commentator on the NY Times Economix blog (see photo). In his most recent blog post titled "Are Bank Examiners to Blame for Slow Job Growth" he refutes bankers assertions that regulators are unnecessarily forcing banks to put loans that are paying as agreed on non-accrual. There is a bill currently circulating around Congress that allows banks to classify these loans as performing. Mr. Johnson testified against the bill.

But in his post (see link below), he makes two comments that bears refutation:

1.  Bank equity is the primary buffer against loan losses.

In the post, Mr. Johnson states "The problem is that some community banks do not have big enough loss-absorbing buffers — the role that bank equity plays." Certainly equity plays the role. But Mr. Johnson's implication is that it is the primary or sole buffer. In fact, against loan losses, the main subject of the post, the bank has a loan loss allowance.

The loan loss allowance has received little attention in the financial crisis. Banks are supposed to set aside a certain amount of reserves for loans to go sour in bad times. But the Financial Accounting Standards Board (FASB) allows banks to reserve for losses only after there is evidence of loss. FASB is now considering allowing banks to reserve on expected losses. This would put them in sync with regulators, that are requiring banks to write down loans on expected losses. But this difference in the treatment of loan loss reserves left banks under-reserved and therefore elevated the need for capital to ascend to greater prominence in absorbing losses from loans.  I understand that putting greater amounts in reserve, or provisioning, reduces profits and therefore equity, so the two are linked. But lets use the loan loss reserve for its intended purpose, shall we?

2.  Banks should have a 30% equity to asset ratio.

You read that correctly. In the post, Mr. Johnson says, "If we had any kind of free market in banking, you would expect banks to have equity funding of at least 30 percent of total assets." The context was bank failure risk is mitigated by FDIC insurance. True for depositors, not shareholders. But requiring $30 million of equity for every $100 million of assets would not yield equity investment returns. If a bank earned $1 million on $100 million of assets, or 1% ROA, that would yield a 3.33% return on equity. That is investment grade corporate bond returns. How many new banks would we see if we require a 30% equity to asset ratio? What rates would we have to charge on loans to achieve a reasonable return?

Mr. Johnson has an excellent resume. But the things he wrote rather nonchalantly are disturbing. I'm not sure they were thought through to their rightful conclusions. 

While making fundamental changes that will dramatically affect how we finance families and small businesses in this country, we must stop elevating lifelong bureaucrats to industry sage status and beating down bankers in the trenches as self-serving idiots. In the end, we are all self-serving, and we have to ask ourselves how do bureaucrats serve themselves. 

What are your thoughts on a 30% equity ratio?

~ Jeff

Economix: Are Bank Examiners to Blame for Slow Job Growth

Article on FASB consideration of loan loss reserve guidelines:

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