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Stanford Professor Not Buying Whining About Bank Equity Requirements

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Stanford B-school prof Anat Admati has a piece in DealBook arguing that banks should have much higher equity cushions and that you should ignore banks' complaints that those cushions will lower ROEs.

We love this article only because she says something that should be engraved on the foreheads of anyone who wants to comment on bank equity:

Bankers use confusing language that presents equity, or “capital,” as a pile of money that banks must “hold in reserve” or “set aside” passively. This confuses capital requirements, which concern funding only, with liquidity or reserve requirements, which concern how funds are invested. It is you, investors, who hold banks’ equity or capital, not the banks that issued it.

Agreed! Except that we usually see journalists sayingthatbanks will have to "hold capital." As far as we can tell banks mostly know what capital is.

In general the column is a summary and popularization of a longer paper comprehensively examining and rejecting various arguments against increasing bank equity requirements. Admati makes the basic Modigliani-Miller point that considering return on equity while ignoring capital-structure risk is a mistake:

Since investors must be compensated for bearing risk, higher leverage increases the required, or expected, return on equity. To judge whether a manager has created value, one cannot simply look at the return on equity; one must adjust for risk. A bank manager can attempt to reach a “target return on equity” by taking on more risk and by using more leverage, but this, in and of itself, does not create value. It does, however, increase fragility and systemic risk.

But, of course, equity holders like the increased leverage because it gives them option value, as they get all the upside while creditors and/or the government bear the downside. That said, equity holders too might prefer somewhat reduced risk of being written down to zero or almost zero a la Lehman and Bear.

We ran a toy model using 10 big banks of various flavors (JPM, BAC, C, WFC, USB, PNC, RF, STI, GS, MS) and got this pile of nothing:

So, erm, yes. Lots of noise here but this suggests that maybe even shareholders have concerns other than ROE.

Beware of Banks' Flawed Focus on Return on Equity [DealBook]

Also: Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive


Let's Talk About: Basel III

The Fed last night unleashed eight zillion pages of Basel III implementation on the universe and I'm tempted to be like "open thread, tell us about your hopes and fears for capital regulation." So do that! Or don't because it is super boring, that is also a valid approach. Still I guess we should discuss. Starting slow though. Banks have to have capital, meaning that they have to fund some of their assets with things that are long-lived and loss-absorbing, like common equity, rather than with things that have to be paid back soon and at face value. The reason for this is that the rest of banks' assets are funded with things that we really do want to be paid back soon and at face value, like deposits, and if the value of those assets declines you don't want those deposits to be wiped out. The rules say that you need capital equal to a percentage of your assets. The game is deciding (1) what that percentage is, (2) what is capital (proceeds from selling common stock, and actual earnings, yes, but, like, deferred tax assets?), and (3) how you count assets (you might want more capital to shield you from losses in, say, social media stocks than you would to shield you from losses in Treasury bonds, so regulators use "risk-weighted assets," so that $1 of corporate bonds counts as $1 of assets, $1 of Treasuries counts as $0 of assets, and $1 of Facebook stock counts as $3 of assets*). Anyway, here are the required capital levels: