The Brown-Vitter bill, which two senators plan to introduce in an effort to dramatically raise bank capital requirements, has caused a range of fairly predictable reactions, and a few strange ones. Here, for instance, is a lobbyist complaining about “raising required capital to comically high levels,” but the comedy is perhaps elusive. But one stylized fact about bank capital that I find a little funny is that it is always the same; after a certain number of drinks this chart is hilarious:
What that says – perhaps a bit unclearly – is that if a bank is going to add some assets, it will do it by taking on debt; and if it’s going to reduce its debt, it will do so by selling assets; and the one thing that it won’t ever do is change the amount of equity it has. Capital ratios change, but capital amounts basically don’t (except to grow verrrrrrry slowly and steadily over time); all the action is in the denominator.
Consider what that chart means for Brown-Vitter: on Friday I calculated that the bill would require adding, in round numbers, $1.2 trillion of capital at the top 6 banks, all at once.1 But that holds bank assets constant, which is not how it generally works. Of course it’s possible that this new law would break the pattern of banks always having the same amount of equity and just adjusting their debt, and cause them to actually increase their equity dramatically; I suspect that’s roughly speaking the intention.
Another possibility is that banks would keep doing what they’ve always done and bring up equity ratios by reducing assets; the amount of equity would remain constant, as it has in the past. On that math, the six big banks would have to reduce assets by $7 trillion. Out of a total of $9.5 trillion currently. So like a 72% reduction in bank lending and investing and what-have-you.2 Eep?
Perhaps there is comedy there though I’m not sure. That chart has been floating around various places but I swiped it just now from this paper,3 by Tobias Adrian of the NY Fed and Hyun Song Shin of Princeton, musing about why it might be. Or, rather, they just assume the constantness of bank equity, and question why amounts of bank debt change. What they come up with is that leverage moves inversely to value-at-risk, which you can sort of see in this chart: Read more »