Thursday, May 7, 2009

What we're getting instead is a muddier guarantee of bank liabilities


The Curious Capitalist –

Stress tests: Maybe it was never about the capital

The Treasury Department will finally be releasing the already endlessly leaked, contemplated and criticized stress tests in a few hours. After that we will be subjected to another confusing month or so of watching the banks deemed to be in need of more capital find ways to meet regulators' demands. Much of this, it appears, will involve the shuffling of paper, as banks convert preferred shares into the common stock that the Obama administration sees as the most important part of the capital base. In the case of the preferred shares acquired by taxpayers last fall at all the big banks, these may be converted into"mandatory convertible preferred" shares—a sort of common-stock-in-waiting.

These plans have been criticized from many quarters (too many to bother linking to) as, well, paper shuffling. Exchanging preferred shares for common doesn't bring any more capital into the banking system, it just tweaks the capital structure.

But here's what occurred to me this morning: Maybe bank capital isn't the issue here. Capital reserves matter a lot in a banking system with no government backstops: That's why, back in the 19th century, banks held capital stashes of 30% to 40% of assets. Capital was the only insurance against a bank run back then. Now the government insures against bank runs—and last fall it dramatically increased the scope of that insurance, with the FDIC explicitly increasing the deposit insurance limit to $250,000 and beginning to guarantee issuance of bank debt, and the Fed and Treasury implicitly making clear that no creditor of any of the biggest financial institutions would be allowed to lose any money anytime soon.

With that capital became largely irrelevant as a safety and soundness issue: Citi could have capital amounting to 2% of assets, it could have capital amounting to -2% of assets, and it simply wouldn't matter as long as the government guaranteed its liabilities—and that guarantee was credible.

Bank capital—and where it comes from—does matter in determining the most equitable way of allocating the costs and benefits of such a big government bailout. It also plays a role in shaping the financial system so it's less likely to implode in the future. That's what this whole stress test thing is shaping up to be about—forcing the shareholders (but not the creditors) of the more troubled institutions to cede more to taxpayers than the shareholders of the less troubled institutions have to.

If I'm understanding him right, economist Simon Johnson's solution to this whole mess is to explicitly guarantee all bank liabilities, subject banks to much tougher stress tests than we've just been through, then force those who fail the test into full government ownership. What we're getting instead is a muddier guarantee of bank liabilities and a muddier assertion of the government's rights. Is it the optimal approach? I don't think so. Is it a horrible approach? We won't know that for years, if we ever do."


  1. donthelibertariandemocrat Says:

    To be noted:

    February 25, 2009

    U.S. Treasury Releases Terms of Capital Assistance Program

    To view the White Paper, Term Sheet and FAQ, visit

    Alongside the forward-looking economic assessments now being conducted by the Federal banking agencies, the U.S. Department of the Treasury today announced the terms and conditions for the Capital Assistance Program (CAP). The CAP is a core element of the Administration's Financial Stability Plan.

    The purpose of the CAP is to restore confidence throughout the financial system that the nation's largest banking institutions have a sufficient capital cushion against larger than expected future losses, should they occur due to a more severe economic environment, and to support lending to creditworthy borrowers.

    Under CAP, federal banking supervisors will conduct forward-looking assessments to evaluate the capital needs of the major U.S. banking institutions under a more challenging economic environment. Should that assessment indicate that an additional capital buffer is warranted, banks will have an opportunity to turn first to private sources of capital. In light of the current challenging market environment, the Treasury is making government capital available immediately through the CAP to eligible banking institutions to provide this buffer. Details of the forward looking capital assessments can be found at

    Eligible U.S. banking institutions with assets in excess of $100 billion on a consolidated basis are required to participate in the coordinated supervisory assessments, and may access the CAP immediately as a means to establish any necessary additional buffer. Eligible U.S. banking institutions with consolidated assets below $100 billion may also obtain capital from the CAP.
    To clarify the broader context and objectives for the Capital Assistance Program, and its role in the Financial Stability Plan, the U.S. Treasury also released a white paper on the program, as well as a set of frequently asked questions. Both can be found at "

    Now, how on earth could revealing that certain banks were insolvent by administering a stress test lead to restoring confidence? It can't. The only way to make sense of CAP is to assume that the govt is going to find out which bank needs what, and then go about helping them get it. The govt guarantee is the only way to restore confidence. In other words, don't worry, because, whatever the needs,the govt will provide them.

    Somehow, the stress tests came to be seen as a search for solvency in and of itself. Don't ask me how, since it doesn't make sense, if you're dealing in confidence. As for bank stocks, one could assume that the price of some bank stocks would go up once they were guaranteed by the govt. On the other hand, that positive is counterbalanced by the possibility going forward of stock dilution in the banks likely to need help and have the stock price rise on govt help. All in all, this has been a strange process. I have to assume that the govt is guaranteeing the solvency of these banks, since that's what I hear them saying.

No comments: