Sheila Bair's Cruelty To Banks Included Trying To Get Them To Hang On To $33bn They Didn't Want

There are so many good stories in Jesse Eisinger's piece in ProPublica about how the Fed let banks return capital to shareholders that they somewhat obscure the central non-story:

In early November 2010, as the Federal Reserve began to weigh whether the nation’s biggest financial firms were healthy enough to return money to their shareholders, a top regulator bluntly warned: Don’t let them.

“We remain concerned over their ability to withstand stress in an uncertain economic environment,” wrote Sheila Bair, the head of the Federal Deposit Insurance Corp., in a previously unreported letter obtained by ProPublica. ...

Four months later, the Federal Reserve rejected Bair’s appeal. In March 2011, the Federal Reserve green-lighted most of the top 19 financial institutions to deliver tens of billions of dollars to shareholders, including many of their own top executives. The 19 paid out $33 billion in the first nine months of 2011 in dividends and stock buy-backs.

That $33 billion is money that the banks don’t have to cushion themselves — and the broader financial system — should the euro crisis cause a new recession, tensions with Iran flare into war and disrupt the oil supply, or another crisis emerge.*

Here's one way to think about bank capital:
(1) Banks should have a minimum capital of X**
(2) If banks have less capital than X, they have to raise more until they have X
(3) If banks have more capital than X, they can get rid of some capital until they have X

There are various ways to get rid of capital; my favorite is the money-burning party but other good ones include paying outlandish bonuses, building trophy headquarters, lavishing gifts on your potted plants to make up for your previous callous behavior, and of course the old standby of losing fuckloads of money on bad trades. All have their adherents. Two that are particularly popular are dividends and share buybacks. These are popular in part because, if you think of capital as money that people were nice enough to entrust to you, then when you don't need it any more it does kind of make sense to give it back to the people who entrusted it to you, though again the other options all have their points too.

But leave that aside for a minute and just think about step (3) of that framework. It's actually an important part, not so much normatively as just logically: if you think that X is the minimum capital level, and you have a level of capital Y > X, then you have more than the minimum, so you could have less. That's what a minimum is. Or put another way: if you could only increase capital, but never decrease it, then "X is the minimum level of capital" would simply be an irrelevancy and capital would slowly creep towards 100%, more slowly in the case of Citi.***

That is I think useful back-story for the stories here, which are mostly of the form "the FDIC wanted banks to have to keep all their capital forever, especially BofA, while the Fed was all 'no, we want to enrich our bankster cronies and also make ourselves look good at the whole rescuing-banks thing, so let's let them pay huge dividends.'" There are specific fights over things like stress test methodologies and accounting for contingent liabilities that are well worth reading about if you find that sort of thing worth reading about.

But ultimately those fights are about "how much capital is the right level right now?" and you can think some useful things about that question. One thing you could think is, boy, path dependency, huh? There is not a lot of suggestion that the FDIC was pushing for capital raises (outside of the TARP repayment context, which is not quite a net raise). This is sort of a useful test of the seriousness of the FDIC's belief: maybe they were right that the banks were all undercapitalized, but if so shouldn't they have been forced to raise capital? Or was every bank that wanted to pay a dividend exactly correctly capitalized? That seems ... odd.

Another thing you can do is go ahead and raise an eyebrow at the personal motivations of the people who wanted capital return:

But the Fed’s stress-test decision was lucrative for shareholders and bank executives, who are increasingly paid in stock. Dividend payments are taxed at lower rates than ordinary income. Merely allowing the banks to pay dividends, buy back stock and pay back the government helped boost shares, albeit temporarily. ... Bank executives such as Dimon and Pandit stood to gain personally from dividend decisions since much of their compensation comes in the form of stock.

Ha! What dicks! Trying to maximize value for the shareholders who employ them and whose interests they represent! And it's quite sensible to believe that bank executives have incentives that are too one-sidedly aligned with the interests of shareholders.

But it's worth noting that the FDIC's incentives are also kind of one-sided. More capital = less chance of bank failure = less payouts by FDIC = more Sheila Bair saying "see? no banks failed. Go me." That's great but of course there's another side because we don't actually want all banks to have 100% capital. You might go so far as to say that the Fed's macroeconomic balancing role might make it more sensitive to the balance it's striking in bank regulation: you want banks that are well capitalized enough to survive, but leveraged enough to support economic expansion. If that was your model you might not be surprised to find the FDIC regularly being more conservative than the Fed, and you might not assume that the FDIC was always right.

One reason that the FDIC could frequently take principled stands against allowing overcapitalized to return capital is that "overcapitalized" is a debatable term. If you measure capital as sort of assets minus liabilities then you have to think about what "liabilities" are, and you sort of start with GAAP and add some other stuff and squint at it and hope it works, but you eventually reach some limit of contingency:

One major concern was accurately measuring legal liabilities. Banks that had assembled mortgage-backed securities often faced accusations of fraud or deception from investors in those securities. Now, the banks faced a threat that courts would force the banks to take back billions of dollars’ worth of toxic mortgages, known as “put-back” risk. With input from the legal department, the Fed had come up with a system-wide estimate for this risk that the FDIC considered too low, according to two people familiar with the process. ...

Estimating these future liabilities was a task the Fed delegated mainly to the banks. In a Dec. 12, 2010, speech, Tarullo said the Fed expected “that firms will have a sound estimate of any significant risks that may not be captured by the stress testing, such as potential mortgage put-back exposures, and the capacity to absorb any consequent losses.” ...

The FDIC was puzzled. “The direct connection between the put-back issue and the stress test never has been clear to me. They didn’t take the number and add it to the bottom line,” says the senior regulator familiar with the FDIC’s position. “They didn’t have any sizing on broader servicing liabilities.”

All the more reason, FDIC officials thought, to slow down the dividend payouts and stock buy-backs.

This is an interesting and legitimate debate but you have to be careful about taking it too far. A point - the point? - of bank capital is that when unexpected bad things happen you have some cushion. To some extent trying to predict all those bad things - like, say, potential verdicts of cases many of which haven't been filed yet - seems like a stretch. And if you take seriously the goal of building a model that correctly accounts for every possible risk and reserves the full cost of those risks - why do you need an 8% capital cushion beyond that? Don't answer that.

Fed Shrugged Off Warnings, Let Banks Pay Shareholders Billions [ProPublica]

* It seems somehow relevant to point out that the $43 in my wallet is also money that the banks don't have to cushion themselves -- and the universe!!! -- from nuclear holocaust.

** Call it X% of A, where X is a number and A is some measure of the category of stuff that you'd like your capital to be a percentage of (RWAs? assets? other? sure!). Or make them arrays: X_1 to X_n% of A_1 to A_n for various categories, really, just, go nuts, pick your favorite numbers. Or make it a sliding scale based on some set of indicators, I don't know. But there is some number or set of numbers; they can be hard to measure but you can usefully abstract it.

*** But, y'know, also normatively. Forcing banks to 100% capital has its problems. Turns out having liabilities is an important thing for banks to do.