The Map and the Territory

by Alan Greenspan

  How much capital counterparties require of financial institutions should influence regulatory capital requirements. It is probably too soon to have definitive long-term answers. But very rough approximations for U.S. commercial banks can be inferred from the response of bank credit default swaps (CDS), a market measure of bank insolvency risk, to postcrisis events.24 (See Box 5.2.)

  BOX 5.2: BANK CAPITAL

  Movements in the CDS market should also give us some direct insight into when the banking system is perceived to have overcome the market’s still prevalent fear of widespread insolvency—and beyond that, to when markets perceive that banks will feel sufficiently secure to return to the free lending of the precrisis years.

  Starting late in 2008 and accelerating into the first quarter of 2009, the U.S. Treasury, through its Troubled Asset Relief Program (TARP), added $250 billion to bank equity, the equivalent of adding approximately 2 percentage points to the equity capital-to-assets ratio. The effect of this added capital was consequential and immediate.

  As the financial crisis took hold and deepened, the unweighted average spread of five-year CDSs of six major U.S. banks—Bank of America, JPMorgan, Citigroup, Goldman Sachs, Wells Fargo, and Morgan Stanley—rose from 14 basis points in early 200725 to 170 basis points just before the Lehman default on September 15, 2008. In response to the Lehman default, the five-year CDS average price rose to more than 430 basis points by October 10. On the day the TARP was announced (October 14), the price fell to 211 basis points, or essentially by half (Exhibit 5.3). In other words, a 2-percentage-point addition to the banks’ book equity capital-to-assets ratio reversed roughly half the crisis surge in the price of five-year CDSs. We shouldn’t make too much of this, but we shouldn’t make too little of it either; it’s a real data point in an argument that has precious few of them. If we assume a linear extrapolation, which is admittedly a big assumption, this implies an overall additional 4-percentage-point rise (from nearly 10 percent at the end of the third quarter of 2008 to 14 percent ultimately) in the equity capital cushion required by market participants to fund the liabilities of banks. (This also presumes, of course, that the probability of a TARP before the Lehman default was de minimis. The abruptness of the market reaction to the TARP announcement appears to confirm such a presumption.)

  Current book equity-to-assets ratios are still far from 14 percent. The average ratio for commercial banks (as reported by the FDIC) was 11.4 percent on March 31, 2013, compared with 9.4 percent in late 2008. That banks still have more equity capital to add in order to return the market’s perception of risk to precrisis levels is also indicated by the fact that the five-year CDS price remained around 100 basis points in the spring of 2013, which was still significantly elevated relative to the 14 basis points that prevailed in early 2007, when 10 percent capital prevailed.26

  There is little doubt that the TARP’s cash injection markedly reduced the fear of bank default through early 2009. More difficult to judge is the effect on bank CDSs of the dramatic increase in bank equity at market value relative to bank assets at market value. That ratio rose from 7.3 percent at the end of March 2009 to 11.6 percent at the end of December 2009 (Exhibit 5.4). (Bank capital-to-asset ratios are typically quoted in book value terms, which is to say the value based on established accounting conventions. Market value is simply the stock price [per share] times the number of shares outstanding.)

  Higher market values of bank equity have materially increased the solvency of banks, though far less effectively, dollar for dollar, than a more permanent change in book value equity. CDS prices, which reflect the probability of default, can be used as a basic arbiter of whether book or market value of bank equity is the more relevant measure of buffer against default. CDS prices and bank stock prices are highly correlated, of course. But statistically significant regression analysis indicates that only one fourth of a change in the ratio of bank equity to bank assets at market value translates to the book value equivalent of that ratio. This is wholly understandable given that market values are more ephemeral than book values. Presumably only a fourth of market change is assumed to be a permanent increase in the buffer to default, measured by book value.

  Much of the repayment of the 2008 TARP investments to the U.S. Treasury was doubtless financed by new equity issuance. That new equity issuance was, in turn, made possible by a more than half-trillion-dollar increase in the market value of U.S. commercial bank equity and by borrowings made much easier (and cheaper) by the increased equity buffer engendered by gains in market-valued bank equity. The parceling of relative contributions of the TARP and of capital gains to bank solvency and willingness to lend may not be fully clear even in retrospect.

  The TARP not only inserted capital but also induced market participants to infer that the U.S. Treasury would, at least for a while, stand behind the liabilities of the banking system. This may explain the divergence since mid-September 2009 between short-term (one- and three-month) London Interbank Offered Rate less overnight indexed swap rates (LIBOR-OIS) spreads (an alternative to CDS spreads as a short-term measure of the likelihood of bank default) and five- and ten-year CDS spreads. Short-term LIBOR-OIS spreads had returned to their precrisis level by the end of September 2009. Long-maturity CDS prices are, as yet, only partway back (Exhibit 5.5). The one-year LIBOR-OIS spread falls in between. Clearly, markets are discounting some of the rise in the bank capital cushion at market value five and ten years hence. That discounting likely reflects the perceived increased volatility of stock prices and the uncertainty surrounding the political willingness, or ability, of the U.S. government, after markets return to normal, to initiate another bank bailout.27

  Given the foregoing set of fragile assumptions and conclusions (they are all we have), I would judge that regulatory equity capital requirements in the end will be seen to have risen from the 10 percent precrisis level (in terms of book value) to 13 percent or 14 percent by 2015, and liquidity and collateral requirements will toughen commensurately.

  What Supervision and Regulation Can Do

  What, in my experience, supervision and examination can do as backup to capital requirements and counterparty surveillance is promulgate rules that are preventative and are not predicated on regulators being able to accurately predict an uncertain future.

  SUPERVISION

  can audit and enforce capital and liquidity requirements,

  can require that financial institutions issue some contingent convertible debt that will become equity should equity capital become impaired,

  can put limits or prohibitions on certain types of concentrated bank lending,

  can inhibit the reconsolidation of affiliates previously sold to investors, especially structured investment vehicles (SIVs),28 and

  can require “living wills” in which financial intermediaries indicate, on an ongoing basis, how they can be liquidated expeditiously with minimum effect on counterparties and markets.

  Some Lessons of Equity Capital History

  In the late nineteenth century, U.S. banks needed to carry equity capital of 30 percent of assets to attract sufficient deposits and other forms of borrowing to fund their assets. In the pre‒Civil War period, that figure topped 50 percent (Exhibit 2.1). Given the rudimentary nature of payment systems and the poor geographical distribution of bank reserves in what was then an agricultural economy, competition for bank credit was largely local. It enabled national banks, on average, to obtain returns (net income) on their assets of well over 200 basis points in the late 1880s, and probably more than 300 basis points in the 1870s (compared with 70 basis points a century later).

  The increasing efficiency of financial intermediation, owing to the consolidation of reserves and improvements in payment systems that allowed capital-to-assets ratios to decline, exerted competitive pressure on profit spreads to narrow. Accordingly, the annual average net income rate of return on equity was amazingly stable, rarely falling outside a range of 5 to 10 percent, measured annually, during t
he near century from 1869 to 1966 (Exhibit 5.6). That stability meant that net income as a percentage of assets and the degree of leverage were roughly inversely proportional during that century.

  The rates of return enjoyed by financial intermediaries on assets and equity (despite the decline in leverage) moved modestly higher during the period from 1966 to 1982, owing to a rapid expansion in noninterest income, for example, from fiduciary activities, service charges and fees, and securitizations. Then, as a consequence of a marked increase in the scope of bank powers, noninterest income again rose significantly between 1982 and 2006, boosting net income to nearly 15 percent of equity. That increase reflected in part the emergence in April 1987 of court-sanctioned and Federal Reserve‒regulated “section 20” investment banking affiliates of bank holding companies.29 The transfer of such business is clearly visible in the acceleration of gross income originating in commercial banking relative to that in investment banking starting in 2000.30

  I tentatively conclude that the relative stability of average net income-to-equity ratios dating back to the post‒Civil War years reflects an underlying competitive market-determined rate of return on intermediation, a result consistent with stable time preference and real long-term interest rates.

  In summary, the crisis of 2008 has left in its wake a significantly higher capital-to-assets ratio requirement, both economic and regulatory, that must be reached if intermediation is to be restored to the point where banks and other financial institutions are confident they have a sufficiently secure capital cushion to lend freely. An open question is whether, in line with history, a rise in the ratio of capital to assets in banks will also nudge up the ratio of net income to assets in the process. This is obviously an implication of higher capital-to-asset ratios.

  Too Big to Fail

  Beyond the need to increase capital requirements, we still face the necessity of addressing the problems of some financial firms being “too big to fail” (TBTF) or, more appropriately, “too interconnected to be liquidated quickly.” The productive employment of the nation’s savings is threatened when financial firms at the edge of failure are supported with taxpayer funds (savings) and designated as systemically important institutions.

  I agree with Gary Stern, the former president of the Federal Reserve Bank of Minneapolis, who has long held that “creditors will continue to underprice the risk-taking of these financial institutions, overfund them, and fail to provide effective market discipline. Facing prices that are too low, systemically important firms will take on too much risk.”31

  After remaining in the backwaters of economic analysis for years, “too big to fail” has finally gained the prominence it deserves. Firms that are perceived as too big to fail have arisen as major visible threats to economic growth. It finally became an urgent problem when Fannie Mae and Freddie Mac were placed into conservatorship on September 7, 2008. Before then, U.S. policy makers (with fingers crossed) could point to the fact that Fannie and Freddie, by statute, were not backed by the “full faith and credit of the U.S. government.” Market participants, however, did not believe the denial, and they consistently afforded Fannie and Freddie a special credit subsidy. It ranged between 13 basis points for short-term debt to 42 basis points for longer-term debentures, with a weighted average of about 40 basis points.32 On September 7, 2008, market participants were finally vindicated.

  Fannie Mae and Freddie Mac need to be split up into smaller companies, none of them too big to fail, and then reconstituted as stand-alone securitizers. Alternatively, they could be phased out by gradually lowering the size of the loans they can guarantee and securitize.

  Seventeen systemically important U.S. banks have been designated by at least one major regulator as effectively too big to fail, rendering them guaranteed by the federal government. As has occurred with Fannie Mae and Freddie Mac, the market has already accorded these TBTF institutions subsidized funding. This is evident in the cost of funding of large banking institutions relative to competing smaller institutions not favored with subsidized borrowings. IMF researchers in a recent working paper estimated “the overall funding cost advantage of global SIFIs as approximately 60 basis points (bp) in 2007 and 80 bp in 2009.”33 The top forty-five U.S. banks in this study exhibited about the same degree of support as the global average. In competitive financial markets, 40 to 80 bp is a very large advantage.

  Such a market-based subsidy will enable a bank or other financial intermediary to attract part of the nation’s savings to fund its operations, even if its policies and portfolio, unsubsidized, would fail. Banks that become inefficient because they chronically fund inefficient firms should be allowed to fail. The viability of our economic system requires it. Even more worrisome, the market players are beginning to conjecture that in the event of the next crisis, most of the American financial system effectively would be guaranteed by the U.S. government.

  As I noted earlier, sovereign credit should be employed as a backstop only during periods of extreme financial breakdown. Sovereign credit is not without cost. It creates institutions that are too big to fail, a short step from crony capitalism (see Chapter 11). More important, it becomes addictive, offering a seemingly politically cost-free avenue to a solution for every conceivable adverse aberration in economic activity.

  ADDRESSING THE DIFFICULT

  How to deal with systemically important institutions is among the major regulatory problems for which there are no easy solutions. Early resolution of bank problems under the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) appeared to have worked with smaller banks during periods of general prosperity. But the notion that risks can be identified in a sufficiently timely manner to enable the liquidation of a large failing bank with minimum loss proved untenable during a crisis in which many large banks were at risk of failing at once. And as I noted in Chapter 2, I suspect solving the problem of large failing banks by “prompt corrective action” will prove untenable in future crises as well.34

  The solution, in my judgment, that has at least a reasonable chance of reversing the extraordinarily large moral hazard that has arisen in the wake of the crisis is, as I noted, to require banks and possibly all financial intermediaries to issue CoCo bonds, as I mentioned earlier. Such debt will, of course, be more costly on issuance than simple debentures.

  However, should contingent convertible bonds prove insufficient, we should allow large institutions to fail. If regulators determine that an institution is too interconnected to liquidate quickly, that institution should be taken into a special bankruptcy facility when normal debtor-in-possession financing is available. When debtor-in-posession financing is not available, the regulator should be granted access to very limited taxpayer funds to facilitate the gradual liquidation of a failed institution. Its creditors (when equity is wholly wiped out) would be subject to statutorily defined principles of discounts from par (“haircuts”), and the institution would then be required to split up into separate units, none of which should be of a size that is too big to fail. The whole process could be administered by a panel of judges who are expert in finance.

  I assume that some of the newly created firms would survive, while others will fail. If, after a fixed short period of time, no viable exit from the bankruptcy appears available, the financial intermediary should be liquidated as expeditiously as feasible.

  An interesting speculation is whether the crisis that emerged in August 2007 from the extraordinary leverage (as much as twenty-five to thirty times tangible capital)35 taken on by U.S. investment banks would have occurred had these firms remained the partnerships that they were nearly four decades earlier. The 1970 New York Stock Exchange ruling that allowed broker-dealers to incorporate and gain permanent capital seemed sensible at the time.36 Nonetheless, as partnerships, Lehman Brothers and Bear Stearns almost surely would not have departed from their historically low leverage. Before incorporation, fearful of the joint and several liabilities to which general partnerships are su
bject, those entities shied away from virtually any risk they could avoid. Their core underwriting of new issues rarely exposed them for more than a few days.

  To be sure, the senior officers of Bear Stearns and Lehman Brothers lost hundreds of millions of dollars from the collapse of their stocks. But none, to my knowledge, has filed for personal bankruptcy.

  A Whiff of the Past

  The prototype for any restoration of partnership finance in today’s environment may well be my very first employer as an economist (in 1947), Brown Brothers Harriman, the oldest and largest privately owned bank in the United States. Because of its partnership structure, it refrained from engaging in much of the risk-laden investment strategies of recent years, and emerged unscathed from the crisis. Its credit ratings are high, its balance sheet highly liquid, and in recent years it has reported no nonperforming loans. This, if my memory serves me, sounds a good deal like the balance sheets that investment banks generally exhibited through most of their existence as partnerships.

  To be sure, since partnerships are limited in size, to do the nation’s business the economy would require a far larger set of financial institutions than exists today. While replicating the incentive structure of partnerships should be a goal whenever feasible in future reform, that goal will doubtless be compromised given that the corporate structure is seen as being required to raise capital on a scale perceived as necessary in today’s global market. To eliminate moral hazard, it should not be necessary to follow Hugh McCulloch, our first comptroller of the currency, in 1863, who went somewhat over the edge in proposing that the National Bank Act “be so amended that the failure of a national bank be declared prima facie fraudulent, and that the officers and directors, under whose administration such insolvency shall occur, be made personally liable for the debts of the bank, and be punished criminally, unless it shall appear, upon investigation, that its affairs were honestly administered.” Under such a regime, moral hazard surely would not exist.