Like I mentioned earlier, the David Viniar show this morning is a good time in its (relatively) quiet way. If, like me, you've drunk the GS we-understand-risk Kool-Aid, you'll particularly enjoy Viniar's take on capital requirements, which is - and I say this as a compliment - pretty cynical. Now, one thing that you might have in your arsenal of thoughts about bank capital is something along the lines of "capital requirements are a way of forcing bank managers to confront the risks of their positions and fund those positions in a loss-absorbing way to protect their creditors and the financial system more broadly." Your faith in that position should I think be a little shaken by some of the Viniar Q&A. For instance:
Roger A. Freeman - Barclays Capital: [H]ow are you charging the desks for capital at this point? Is it on a Basel I basis or Basel III or some combination?
David A. Viniar: ... As far as how we're charging the desks, that's a little bit of a complicated question. And we're working through that now, and it -- there's no one-size-fits-all yet. And we have to be careful. As you know, Basel III does not kick in for quite a while, and quite a bit of what we do is very short dated. And so we don't want to charge desks on a Basel III basis, have them turn down profitable opportunities that would be long gone from our balance sheet long before Basel III ever kicks in. So we're really taking into consideration the tenor of what we do and trying to figure out what capital regime we're going to be under. And it's still -- I would say, we're going through a transition process here.
On the one hand, totally unsurprising and unobjectionable. On the other hand note the pragmatism: if and when our regulators are going to charge us for capital under the (generally higher) Basel III rules, we will charge desks for capital based on those rules. If not, not. The rules are the rules and the transition to new rules will be made in accordance with the rules. Only. If you thought "well, Basel III will improve the health and safety of banks by steering them away from the riskiest worst scariest products" - guess what, Goldman disagrees. They'll manage capital to whatever regime is in place, as a matter of complying with regulation, but the capital rules appear to have no effect whatsoever on how they actually think about the risks of their assets, trades and businesses.
Are they wrong? Well, a while back I sort of baselessly speculated on rumors that Goldman was looking into abandoning mark-to-market for some of its loan book, pointing out that this sacrifice of principle could help it compete on relationship loans that help win other business. Viniar chatted about this very topic on the call with Howard Chen of Credit Suisse and it turns out there's another important element:
We're looking at the accounting treatment for just, what I would call, a portion of the relationship loan commitments. ... [T]he consideration is being driven by the more onerous capital treatment for the fact that the same assets held on mark-to-market versus a held-for-investment basis are different. I mean, it's much more onerous for mark-to-market. So that's what driving even our consideration. You should know, and I will use this word, we are still fanatical believers in mark-to-market. Substantially all of our assets today are mark-to-market. Our risk is managed on a mark-to-market basis. And whatever we conclude on, what I'll call, a very small portion of assets, just relationship lending, those statements will still be true. Substantially all of our assets will be mark-to-market, and we will manage all of our risk on a mark-to-market basis. So nothing will change there.
Remember, of course, that there's no difference at all in the economics of a "mark-to-market" versus "held-for-investment" relationship loan. In each case, you lend $100 up front and get a stream of payments with a present value of $95 or whatever. If you're mark-to-market like GS and MS, you mark that $5 loss up-front and are sad; if you're hold-to-maturity like most banks, you book the stream of payments as received and, if all goes well, never have any accounting loss. But that's just accounting. The cash flows that happen in the world are the same cash flows.
Goldman manages its balance sheet on a mark-to-market basis: that is, as much as possible, it takes the present value of all its expected cash flows and sees what happens to that value over time, booking gains as it goes up and losses as it goes down, without worrying about whether some of those cash flows are "held to maturity" or whatever. It's one way to live your life, probably a good one if you're a financial intermediary. Basel, on the other hand, has different capital requirements for loans that are "mark to market" versus "held for investment," which maybe has some historical justification in the kinds of entities that once mostly did the one versus the other, but has absolutely nothing whatsoever to do with the underlying characteristics of the assets or with the risks of holding them. And so Goldman will pick the approach that gets the best capital treatment - but that will have absolutely nothing to do with how it thinks about the risk of those assets.
I guess the lesson is, if you enforce bank capital requirements that are encrusted with senseless formalism, you'll get banks who treat those requirements as senseless formalities. Maybe that's fine. Maybe your view on capital requirements is "bankers can think they manage risks well but the only way to keep the system safe is to have blunt-force capital rules that provide some loss absorption when all their risk management goes pear-shaped." That's a perfectly fine view. But if your view is of the form "regulators should figure out the bad risks and get rid of them," then the occasional senselessness in the rules should give you pause - and you should get worried when it's obvious, as I think it is from the Goldman call, that the banks are thinking harder about risk than the regulators are.