Have Some European Bank Deleveraging / US Bank Releveraging

I'm back! What'd I miss? Well, that one thing. Also yesterday the BIS put out its quarterly review, which ponders the state of the world financial system, complete with ugly charts* and a cheering story of European bank deleveraging that goes something like this: As deleveraging pressures grew towards the end of 2011, European banks offered for sale a significant volume of assets, notably those with high risk weights or market prices close to holding values. Offerings with high risk weights included low-rated securitised assets, distressed bonds and commercial property and other risky loans. Although some such transactions were completed, others did not go through because the offered prices were below banks’ holding values. Selling at these prices would have generated losses, thus reducing capital and preventing the banks from achieving the intended deleveraging. Thoughts could be thought about that collection of words!
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I'm back! What'd I miss? Well, that one thing. Also yesterday the BIS put out its quarterly review, which ponders the state of the world financial system, complete with ugly charts* and a cheering story of European bank deleveraging that goes something like this:

As deleveraging pressures grew towards the end of 2011, European banks offered for sale a significant volume of assets, notably those with high risk weights or market prices close to holding values. Offerings with high risk weights included low-rated securitised assets, distressed bonds and commercial property and other risky loans. Although some such transactions were completed, others did not go through because the offered prices were below banks’ holding values. Selling at these prices would have generated losses, thus reducing capital and preventing the banks from achieving the intended deleveraging.

Thoughts could be thought about that collection of words!

Like all the BIS reviews this one comes with a collection of bonus goodies and the highlight here seems to be a paper saying "Our analysis shows that it is cheaper for banks to raise capital during an economic expansion than in a recession," so, um, fewer thoughts could probably be thought about that, but let's hear them out:

The low hurdle rate for investment in a boom can have a procyclical effect. It encourages credit growth that can further boost economic activity. From a prudential viewpoint, this evidence supports the rationale behind the introduction of countercyclical capital buffer requirements, which increase in booms and decline in busts. This would provide a concrete incentive for banks to build buffers when equity is relatively cheap, rather than having to do so after capital is depleted and the cost of balance sheet repair is higher.

Ooh ooh also - they can build equity during booms by selling assets and booking gains, rather than selling during busts and booking losses. Anyway, equity is good for everyone:

One of our findings is that even though the equity market rewards leverage with higher returns, balance sheet gearing also comes with higher stock price volatility. In fact, most of the increased volatility in bank stock returns associated with higher leverage is not priced in the market. This means that stricter capital rules not only reduce leverage and lower the required return in the stock market, but also reduce non-remunerated volatility for the holders of bank equity, making diversification easier. Moreover, the fact that lower leverage goes hand in hand with lower required returns downplays industry concerns that higher capital requirements will imply a material increase in funding costs. The finding that G-SIBs [global systemically important banks] enjoy a lower cost of capital compared with other banks with similar characteristics supports the motivation behind the requirement for capital surcharges decided by the international policy community.

So isn't that nice? The paper is mostly a wonktacular assortment of regressions but it claims that G-SIBs or G-SIFIs have a cost of equity capital that is about 200bps lower than that of similarly levered non-G-SIB banks, and I guess this non-remunerated volatility point is a point too.

I'm vaguely dissatisfied by the claims that raising equity requirements for banks will not increase their cost of funding because, y'know, equity is expensive and screw your Modigliani-Millerizing, but I suppose that could be wrong. The BIS folks are certainly cheerful that more equity is better for cost of funds purposes and they have a bunch of regressions and stuff so who am I to complain. Part of who I am to complain is a guy with a bias that providing high returns to shareholders is a good thing; the BIS comes from the perspective of expectations management - just make your shareholders expect lower returns - which is good and finance-theory-y but not as fun as saying "we had a 40% ROE" on your earnings call.

You could think some standard boring thoughts about this, like for instance that bank executives might have share-based-compensation reasons to prefer high returns on equity - and even high volatility - over a lower overall cost of funds. Those standard boring thoughts could lead you to a standard boring theory of banking regulation as upholding the socially beneficial purpose of banks - funding economic activity inexpensively - against rapacious shareholder-executives who only want to improve returns for shareholders. Then your theory might founder against a sentence like "Selling at [market] prices would have generated losses, thus reducing capital and preventing the banks from achieving the intended deleveraging."

Meanwhile in another part of town US banks seem to have somewhere between quite enough and too much capital:

J.P. Morgan says it is boosting its quarterly dividend to 30 cents a share from 25 cents a share and authorizing the repurchase of up to $15 billion in shares. Banks were expected to learn about how they fared on stress tests this week, and J.P. Morgan was always expected to be approved to boost the payout and buybacks it had. J.P. Morgan said in its release that the Fed had not objected to any of its plans in the stress tests.

This should enjoyably enrage the whole nobody-should-ever-pass-a-stress-test-or-return-capital crowd. But you could argue that this is in some rough way the sort of countercyclical capital that the BIS researchers like: after all, JPM was returning scads of money to shareholders in 2011 when European banks were deleveraging, and both sides of that seem set to continue. (Though you could also maybe argue that, from a share price perspective, US banks aren't exactly at the trough of their own cycle.) Plus, of course, it lets Jamie Dimon talk about a higher ROE on his earnings call, and maybe even make some money on the trade. (Maybe!) Everybody wins.

BIS Quarterly Review, March 2012 [BIS, full pdf]
Bank stock returns, leverage and the business cycle [BIS]
JP Morgan Passes Stress Test, To Boost Dividend Payment [Deal Journal]

* I realized I've whined about these charts before but holy god. Who makes the editorial decision to have your main color palette be like khaki on gray? Also, like, scales, man:

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