• 27 Jan 2012 at 1:43 PM
  • Banks

And Now An Argument That More Capital Makes Banks Less Safe

One reason that you’re in for seven lean years in the investment banking business is that bank capital requirements are going up due to Basel III, and “capital is expensive” in some loose sense, so banks will have less money to use to make loans and/or pay you. Some people think that this is mostly bull, because capital is not actually any more “expensive” than any other form of funding, though those people often actually don’t care that much about paying you so it may not be worth listening to them. In any case here is the abstract to an amusing new paper by Karlo Kauko of the Finnish central bank, because yes I make a point of being up to date on everything published by the Finnish central bank:

Bank managers often claim that equity is expensive relative to debt, which contradicts the Modigliani-Miller irrelevance theorem. … An opaque bank must signal its solvency by paying high and stable dividends in order to keep depositors tranquil. This signalling may require costly liquidations if the return on assets has been poor, but not paying the dividend might cause panic and trigger a run on the bank. The more equity has been issued, the more liquidations are needed during bad times to pay the expected dividend to each share.

Don’t worry if you don’t get that name dropping, it doesn’t matter. Also don’t worry too much about the paper itself, which is amusing but also sort of nuts.* The basic idea to come away with is that bank equity is where the bank puts all its hopes and dreams, and that, if banks are more or less reflections of hopes and dreams, the people who provide the real funding for the banks – repo counterparties and clearing banks and suchlike – are going to be inordinately influenced by reading equity tea leaves. Because what else are they going to read?

Complex banking organisations, where the true leverage cannot be accurately estimated by outsiders, are more likely to consider equity capital expensive. A bank with simple operations, a transparent balance sheet and no off-balance sheet risks cannot mimic high profitability by choosing an extreme leverage and paying a high and steady return on a tiny equity capital. Interestingly, minimising the capital base seems to have become more commonplace when banking has become more complicated. The true leverage of modern large and complex banking organisations can hardly be deduced from public information.

In Kauko’s story the way that banks signal to depositors – for which read “repo counterparties and suchlike” – that everything’s fine is by paying big, stable dividends on their equity. Surely if a bank is paying a healthy dividend, which after all it could cut off at any time, it won’t have any trouble paying off its debts, right? The problem is that this makes the dividend something like a real cash obligation for a bank in crisis: if it cuts the dividend, it will signal to lenders that they’re next, and they’ll all stampede for the exits. So equity is “expensive” in that it requires banks to fork over lots of cash for dividends.

This is to some degree news to regulators, who like equity precisely because it has no cash cost when banks really need to conserve cash – like I said, the banks can always cut the dividend. But it’s probably correct to say that (1) like a quarter of every bank earnings call these days is taken up with “so, when will the regulators let you raise your dividend or buy back more stock?” and (2) there is a pretty strong link in many people’s – investors’ and bankers’ – minds between “the regulator is letting us pay more dividends” and “we are probably not going to blow up all that soon.” So this seems like a good point:

The model has at least one obvious policy implication. If the public observes clear symptoms of a recession, it is reasonable to restrict banks’ dividend payments. If such a regulation is enforced and applies to all banks, dividend cuts tell nothing about the profitability of any particular institution, and bank solvencies could be enhanced with retained earnings without bank-specific adverse signalling effects.

In a way this happens now – bank regulators are keeping a closer eye on everyone’s dividends and buybacks than they were in 2007, even healthy-ish banks – but the blanket dividend restriction in a crisis is maybe a good idea, akin to making all the banks take TARP to avoid stigmatizing the banks who really needed it.

Like I said, this paper is sort of nuts and maybe doesn’t tell you exactly why bank capital is expensive or whatever. But I like the basic move, which is to remind us that with bank balance sheets so opaque, the short-term lenders who mostly fund banks will have to grasp at whatever imperfect indicators they can find – and that they will react to those imperfect indicators in ways that are weird and unintended. Things that should preserve capital and make a bank safer, like cutting its dividend, may have the opposite effect. Not sure that that means that more capital = more danger, but it’s at least a reminder that more capital doesn’t = no danger either.

Why is equity capital expensive for opaque banks? [Bank of Finland via the BIS research hub]

* Because its core belief is that banks don’t like equity because it requires them to pay out more actual cash dollars in a crisis than alternative funding sources do, and that just can’t be right. The paper’s model breaks down bank funding into two things, dividend-paying equity and interest-bearing deposits, and more or less postulates that the “dividend is higher than any deposit rate the bank might offer, consistently with at least some casual empirical observations on banks’ dividend policies,” which, like, that’s just your opinion man, but banks in fact fund using a range of seniorities and tenors and pay a range of rates on their debt funding instruments and it strikes me as hardly set in stone that your blended interest expense will be less than your dividend; JPM’s is (crudely I get interest expense / total liabilities = 0.65%, div yield = 2.67%), but BAC’s isn’t (1.14% vs. 0.55%) and neither is GS’s (1.5% vs. 1.28%). And that’s in a pretty pretty low rate environment. Once you get away from the belief that equity has a higher cash cost for banks than debt, which is implicitly assumed and also, like, obvs wrong, you start to wonder about the results. I’m being a little unfair because yeah probably the average bank pays a higher dividend than it pays on its shortest-dated most run-sensitive funding, but I suspect that’s the wrong margin to look at. Whatever.

67 comments (hidden to protect delicate sensibilities)
Show all comments ↓

Comments (67)

  1. Posted by Guester | January 27, 2012 at 1:50 PM

    Matt this is way too long

  2. Posted by guest guestheimer | January 27, 2012 at 2:01 PM

    I got 3 paragraphs in and realized that I'd rather listen to hold music than read this bullshit. Sorry Matt.

  3. Posted by The Truth | January 27, 2012 at 2:07 PM

    Modigliani-Miller is the stupidest thing in all of finance. Except for CAPM, EMH and all the other stupid stuff.

    – guy who is not a CFA and vehemently disagrees with just about everything they make you learn for Level II

  4. Posted by Alan_Stanwyk | January 27, 2012 at 2:09 PM

    200 word footnotes are Matt's NKI

  5. Posted by HomoBro | January 27, 2012 at 2:10 PM

    All I want out of life is to be a monkey of moderate intelligence who wears a suit.

  6. Posted by Simulation | January 27, 2012 at 2:13 PM

    Enjoyed the read. It was not too long. Equity Capital, Tier 1 or however you measure the safety and soundness of banks has morphed over the years. Each revision is more complex than the previous, and for some, the complexity means more defined, thus a better measure. This is illogical. Banks like JPM weathered the crisis very well. Perhaps their model is correct. Higher capital levels are probably a function of it, but I'm sure the other variables that come in to play are too many to list. Lesson learned, run your business/institution/bank robustly, and be prepared for the adverse effects from unintended consequences and randomness. These new regulations are just going to be a platform for further research on the topic. At least there will be jobs.

  7. Posted by FKApmco | January 27, 2012 at 2:16 PM

    The Commentariat is focused on job cuts and bonus numbers and Matty gives us a chapter on a Finnish central banker's amusing and sort of nuts thoughts on bank capital.

    This is why I love Matt Levine and want to go and live in his world.

  8. Posted by Jeffrey VInik | January 27, 2012 at 2:35 PM

    What are you talking about? That's how I do all my analysis.

  9. Posted by Matt | January 27, 2012 at 2:37 PM

    My mom says I can't close the door when you are over, are you cool with that?

  10. Posted by FKApmco | January 27, 2012 at 2:42 PM


  11. Posted by GrapeVine | January 27, 2012 at 2:43 PM

    Modigliani-Miller just got busted in a pump and dump scheme. They were caught in Amsterdam with a bunch of strippers…euro-less.

  12. Posted by guest | January 27, 2012 at 2:51 PM

    the goal of the comment section is not to engage matt in an intellectual discussion. We just call him names and stuff.

  13. Posted by Pauly D | January 27, 2012 at 3:29 PM

    Yeah Buddy

  14. Posted by trojan_ | January 27, 2012 at 3:32 PM

    he can write freely about wonk capital regulations because he doesn't have to worry about the former or the latter

  15. Posted by FA in steel city | January 27, 2012 at 4:28 PM

    time for an afternoon dump will read in bathroom

  16. Posted by Ihateyou | January 27, 2012 at 6:14 PM

    Modligliani Miller only applies in a zero-tax environment

  17. Posted by Per Kurowski | January 28, 2012 at 8:41 AM

    This is another important angle of how the capital requirements for banks based on officially perceived risk has messed it up.

    Consider… what if terrorist infiltrated bank regulations? Would that not be more something for the Homeland Security than for the SEC and the FED and the Dodd-Franks? http://bit.ly/xdSQLn

  18. Posted by crork | September 9, 2012 at 8:20 PM

    CjhDxs I really like and appreciate your blog.Much thanks again. Keep writing.

  19. Posted by lawlaholic | September 11, 2012 at 7:46 AM

    I cannot thank you enough for the blog.Really thank you! Will read on…

  20. Posted by empowernetwork | September 11, 2012 at 12:27 PM

    Thanks again for the post.Much thanks again. Cool.

  21. Posted by görögország | September 11, 2012 at 1:59 PM

    Great blog post.Really thank you! Will read on…

  22. Posted by toronto limo | September 12, 2012 at 4:29 AM

    Yeah, it is clear now !… Just can not figure out how often do you update your blog?!…

  23. Posted by onebuckresume llc | September 12, 2012 at 11:11 AM

    I really enjoy the blog post.Thanks Again. Fantastic.

  24. Posted by satnam | September 12, 2012 at 11:23 PM

    Thanks for sharing, this is a fantastic article.Really looking forward to read more. Want more.

  25. Posted by SAP BASIS | September 13, 2012 at 4:16 AM

    I really liked your article.Really thank you! Really Cool.

  26. Posted by diamants | September 14, 2012 at 4:57 PM

    Thank you for your blog post.Thanks Again. Fantastic.

  27. Posted by food for pregnant women | September 15, 2012 at 8:32 AM

    Really appreciate you sharing this blog article.Much thanks again. Fantastic.

  28. Posted by legitimate home business opportunities | September 17, 2012 at 1:51 AM

    Very informative article.

  29. Posted by bloom photosynthesis | September 17, 2012 at 6:52 AM

    Thank you for your article. Cool.

  30. Posted by textured ceiling repair | September 18, 2012 at 10:49 AM

    I cannot thank you enough for the blog post.Really looking forward to read more. Will read on…

  31. Posted by Trainingen | September 18, 2012 at 4:02 PM

    Awesome article.Thanks Again. Really Great.

  32. Posted by Visitez 1001bonnesaffaires.com | September 18, 2012 at 6:59 PM

    A round of applause for your blog.Much thanks again. Will read on…

  33. Posted by Rottweiler cucciolo | September 19, 2012 at 12:21 AM

    Thanks for the blog article. Great.

  34. Posted by freemusicdownloadsites.org | September 19, 2012 at 1:07 PM

    Thanks for sharing, this is a fantastic article. Cool.

  35. Posted by Zombies movies | September 20, 2012 at 11:11 AM

    Major thanks for the article post.Really thank you! Awesome.

  36. Posted by Mobile Media Millions | September 20, 2012 at 1:48 PM

    I am so grateful for your article.Thanks Again. Will read on…

  37. Posted by cheap bookmarking service | September 20, 2012 at 4:00 PM

    TP6Ktv wow, awesome blog article.Really looking forward to read more. Great.

  38. Posted by Rob | September 20, 2012 at 5:47 PM

    It’s arduous to seek out knowledgeable folks on this matter, but you sound like you know what you’re speaking about! Thanks

  39. Posted by best snoring pillow | September 21, 2012 at 10:39 AM

    Fantastic blog.Really looking forward to read more. Will read on…

  40. Posted by where to buy nopalea | September 21, 2012 at 7:10 PM

    I really like and appreciate your blog post. Fantastic.

  41. Posted by utah restaurant | September 21, 2012 at 10:01 PM

    Awesome blog article.Much thanks again. Really Great.

  42. Posted by internet advertising | September 22, 2012 at 1:48 AM

    I really enjoy the post.Much thanks again. Fantastic.

  43. Posted by management | September 22, 2012 at 4:40 PM

    Thanks for the article.Really looking forward to read more. Great.

  44. Posted by aftermarket rims | September 23, 2012 at 7:25 AM

    Fantastic article post.Really looking forward to read more. Will read on…

  45. Posted by numerology calculator free online | September 24, 2012 at 5:47 AM

    I really liked your article.Thanks Again. Much obliged.

  46. Posted by one buck resume | September 24, 2012 at 11:24 AM

    Hey, thanks for the post.Really thank you! Fantastic.

  47. Posted by How to | September 25, 2012 at 4:45 AM

    Thank you for your post.Really thank you! Much obliged.

  48. Posted by New EDM Music | September 25, 2012 at 4:46 AM

    A round of applause for your post. Awesome.

  49. Posted by online portal | September 25, 2012 at 8:34 AM

    Thanks a lot for the article post.Much thanks again. Fantastic.

  50. Posted by how to do self hypnosis | September 25, 2012 at 7:57 PM

    Wow, great blog article.Much thanks again. Keep writing.

  51. Posted by moved here | September 26, 2012 at 9:34 AM

    Thanks for the blog post.Really thank you! Keep writing.

  52. Posted by Online Goldmine | September 26, 2012 at 3:58 PM

    Major thankies for the article post.Really looking forward to read more. Will read on…

  53. Posted by Oakton homes for sale | September 26, 2012 at 5:00 PM

    Appreciate you sharing, great post.Really looking forward to read more. Cool.

  54. Posted by Learn more on African Mango | September 27, 2012 at 12:42 AM

    Needed to compose you one bit of observation in order to thank you very much the moment again with the incredible principles you’ve shown above. This has been simply strangely generous of you in giving unhampered exactly what many individuals would have advertised for an ebook to end up making some cash for themselves, mostly now that you might have done it in case you wanted. Those concepts as well acted like the easy way to fully grasp some people have similar interest just as mine to see a whole lot more with reference to this matter. I think there are numerous more fun occasions ahead for people who look into your blog post.

  55. Posted by gif maker | September 27, 2012 at 5:15 AM

    Great post.Much thanks again. Great.

  56. Posted by amateur porn | September 27, 2012 at 11:52 PM

    Thanks a lot for the blog article. Much obliged.

  57. Posted by foot rest | September 30, 2012 at 10:41 PM

    This is one awesome blog. Great.

  58. Posted by printer ink refill | October 1, 2012 at 2:49 AM

    Awesome blog article.Much thanks again. Really Great.

  59. Posted by Jordan Gionson | October 1, 2012 at 11:32 AM

    Jeanius said on September 20, 2012

  60. Posted by Finance | October 7, 2012 at 4:03 AM

    Very informative post.Much thanks again. Awesome.

  61. Posted by Drivers Ed Material and Training | October 7, 2012 at 3:35 PM

    See it for the first time!!…

  62. Posted by paper carrier bags | October 8, 2012 at 8:04 AM

    Can be also this issue because the truth can be achieved only in a dispute :D

  63. Posted by debt relief | October 8, 2012 at 1:06 PM

    Strange but true. Your resource is expensive. At least it could be sold for good money on its auction!…

  64. Posted by marketing websites | October 12, 2012 at 8:05 PM

    As usual, the webmaster posted correctly..!

  65. Posted by Burundi tours | October 13, 2012 at 3:43 AM

    Thanks for all the answers:) In fact, learned a lot of new information. Dut I just didn`t figure out what is what till the end!…

  66. Posted by Debt Funding | July 19, 2013 at 7:07 AM

    Very useful information on capital requirement. Really got so much to read and learn from here. Keep posting about financial management and strategic planning for business rise.

  67. Posted by reseller tanpa modal | August 18, 2013 at 3:33 AM

    i can't argue with you matt on this issue reseller kaos distro