Capital Ratios Set Too High For U.S. Banks

There is too much capital in the American banking industry. Statistics released by the International Monetary Fund indicate that the average U.S. bank has a capital-to-assets ratio of 8.2%. On average, banks in other major industrial countries have ratios of 5.75%.

History argues that banking systems with excess capital tend not to support their economies.

In fact, high levels of bank capital seem to correlate more closely with recessions or worse. Despite that fact, U.S. policymakers are striving to increase bank capital ratios (and/or loan-loss reserves) above the current levels.

They are doing this for three reasons:

* They have not attempted to assess the relationship between bank capital ratios and economic activity and, therefore, are unmindful of the connection.

* They do not care what that relationship is because they have established a new agenda for the financial product industry. It appears to be the government's intent to replace much of the traditional banking industry with nonbank financial companies.

* The government finds the new concept appealing because the nonbank companies do not require deposit insurance or other guarantees. Therefore, presumably, the taxpayer would not be directly burdened by the cost of "making good" on the obligations of these nonbank financial institutions if they fail.

These policies have emerged because most Washingtonians cannot fathom why the depository institutions industry has been in crisis for so long. What is clear is that the cost of this disaster, which is totally unacceptable, must be borne.

The net result is a desire to adopt any policies that alleviate the stress, and supporting the nonbanks to take over banking businesses is ideal in this regard.

Nonbanks Are Unproven

The risks related to this program are high, however. It has not yet been demonstrated that nonbanking companies can effectively replace banks as providers of funds to the overall economy. It they cannot or are unwilling to act, a severe economic setback is still a consideration. Certainly many sectors of the economy will be shut out by these new policies -- mainly mid-size business that previously depended on the banks.

But most important, these policies are dramatically returning the nation to unregulated financial activity. This has never been successful for more than short periods.

The shame is that this whole process seems to be happening without debate. In the multifaceted discussion about banking in Congress at present, the historical parameters are being ignored in favor of what appear to be short-run palliatives.

High capital ratios do little for the economy or the banks.

Historical Ratios Unknown

It is probable that the regulators do not know how much capital is in the U.S. banking system. Moreover, it is certain that they do not have any indication of what bank capital levels have been relative to assets in the past. Conversations with a number of policymakers reveal that they have not even attempted to make these determinations.

Assume first a very narrow definition of capital. It is all of the equity invested in a bank plus the reserves, already set aside, that will not be needed to cover loan losses. If this definition is correct, the problem in defining bank capital centers on ascertaining the level of excess reserves in the system.

In order to determine this number, it would be necessary to evaluate a series of aggregate bank balance sheets over a number of economic cycles to estimate how much of the industry's reserves are not used to cover bad loans. It is doubtful that the numbers exist to make this evaluation, but as indicated, no one is looking.

There are even problems in attempting to calculate what equity has been in the past. Definitional changes in the numbers make the Federal Reserve series difficult to work with. Also, despite the fact that the chairman of the Federal Reserve constantly cites figures about bank capital 100 years ago, his source for these data is suspect: the Office of the Comptroller of the Currency's annual reports in the late 1800s.

Dangerous Capital Levels

What is clear is that even the rudimentary series constructed from the spotty information available suggests that bank capital can rise to levels that will close down the U.S. economy.

The Fed chairman delights in speaking about the high bank capital-to-assets ratios 100 years ago. But he neglects to mention that from 1867 to the early 1900s these high capital ratios contributed to almost four decades of deflation (actual continuous price declines). Moreover, this period was one of constant decline in national income, and of social instability punctured by major financial crises in 1873, 1883, 1893, and 1907.

Another period when bank capital ratios rose meaningfully was during the Great Depression. Banks simply refused to lend money, and bank capital rose while the economy remained in disaster. In both eras large companies dominated the economy, and small to midsize business initiatives were crushed because of a lack of funding.

The whole issue of high capital ratios would be suspect even if the historical record were no so chilling. There is little evidence that high capital ratios prevent banks from failing. Contemporary history bears this out.

The Texas banks were among the best capitalized in the industry just before the energy industry collapsed. The high capital levels of these institutions did not prevent them from failing. The same was true in New England, where highly capitalized banks followed that defense-related economy into a downward spiral and failure.

The flaw in capital analysis is the tendency to equate capital with cash. There is a belief that the cash capital invested in the bank at its founding or in subsequent financings still exists as a cash reserve today.

The reality, of course, is that the bank management has reinvested the cash capital in a variety of assets, most of which are not liquid. Once this happens, capital is relatively illiquid.

Therefore, when a bank experience a cash flow problem because the return on its assets plummets or depositors take funds out (as in the Southwest and New England), capital is not readily accessible. It cannot offset the cash drain and allow the institution to keep functioning. Only cash can do this.

Investors Turn Away

In these periods banks have great difficulty in raising the needed capital cash because the discouraging returns on investment deter new investors. Further, as the problem institution strives to obtain cash to meet its shortfall it sells holdings with high returns, retaining problem assets. This downgrading of the mix lowers the company's return.

If the assets sold bring in enough new dollars and the remaining holdings do not continue to provide lower returns, the institution survives. If the new dollars are meager, relative to the continued slide in cash flow from the resource base, the company fails.

When the government makes after-the-fact decisions to raise capital levels, it only exacerbates the negative trends. Troubled banks are now forced to raise more capital than would otherwise be the case. This means more sales of high-quality assets and a higher percentage retention of problem loans.

Capital Issue Masks Real Intent

It is difficult to assume that most industry and government officials do not understand the downward spiral created in bad times by demands for greater amounts of capital relative to assets in the banking system. Yet the desire for more capital and more reserves persists.

This demand - considering the current realities in the banking industry, the theory of capital just explained, and the levels of capital held by foreign banking institutions - shows that the government has a different agenda than the bankers do.

While bankers want their institutions strengthened so they can grow with the U.S. economy, the policymakers simply want to rid themselves of the banking problem - that is, shrink the size of the bank industry and its potential call on the Treasury.

It is believed that nonbanking companies can fulfill the nation's need for financing without the backstop of FDIC insurance. The safety net constructed 55 years ago to hold this system together is no longer believed to be as necessary. For some reason it is felt that industrial companies make better lenders than banks do.

Return to |Wildcat' Banks

But if the nation continues to rely on industrial company paper, as opposed to bank paper, to fund its activities, it will have reverted to the pre-Civil War system of "wildcat" banks. These entities issued as much in banknotes as the market would accept - not as much as they could support. The lack of regulation of their activities resulted in massive depressions in 1818, 1837, and 1857.

Unlike the period from 1818 to 1937, the past 55 years have seen prosperous growth in the United States.

But tampering with the systems from the 1930s has accelerated to the point where we may be about to reinstitute a system that contains the worst of the earlier periods.

Mr. Bove is a banking consultant with the Bove Group in Chatham, N.J.

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