CHICAGO — Bankers and regulators have long struggled with the question: how much capital is enough?
But a panel of experts speaking at a conference hosted by the Federal Reserve Bank of Chicago demonstrated Thursday that the debate isn't just over the amount of capital, it's what kind of capital banks are holding that may matter more.
Following is a recap of the differing views:
Equity is king.
"Equity is the only reliable capital," argues Anat Admati, George G. C. Parker Professor of Finance and Economics at the Graduate Business School at Stanford University. Other kinds of capital, on the other hand, are not nearly as effective and hard to design.
"The system that was in place to make sure there was sufficient loss-absorbing capacity clearly failed to protect the system and massive intervention was necessary," Admati writes in a recent paper.
While better resolution procedures for distressed firms are necessary, they shouldn't be viewed as an alternative to having better capitalized banks or a reason not to regulate, she recommends. "Since such procedures are not likely to eliminate the cost of financial distress, reducing the likelihood that a resolution procedure is needed is clearly important, and higher equity requirements are the most effective way to do so."
Crises, she argues, happen because of too much debt, not because of too much equity. If banks have more equity, it'll reduce the risk of distress and failure and lower the "too big to fail" subsidies.
What's more, banks' balance sheets, which tend to hide a lot of risk and exposure, are unreliable. "The models that were used to assess value at risk were fundamentally flawed," she says. Even if enforcement is a challenge, it's not a reason not to regulate, she stresses.
Actually, not so. Cash is king.
But Richard Bove, a banking analyst with Rochdale Securities, says higher equity doesn't necessarily make a bank any safer, and there's no evidence to prove it either.
For example, if one were to look at the balance sheets of two banks in 2006 — Citigroup [NYSE:C] and Northern Trust [NASDAQ:NTRS] both held similar amounts of common equity to assets.
However, in the nine quarters between the last quarter of 2007 and last quarter of 2009 both institutions reported a pre-tax loss of $68.7 billion, or 57.4% of its equity (Citi) and $2.1 billion, or 53.9% of its equity (Northern Trust). The difference between the two banks was liquidity, not capital, says Bove.
"If Citigroup's common equity was double the actual amount in 2006 and Northern Trust had half the amount of common equity, Northern Trust would still have been a safer bank," says Bove. "The mantra that more and more capital will protect the banking industry makes no sense. High liquidity ratios and solid underwriting protects a bank."
Taking the argument further, he explains, a much more reliable indicator of the health of an institution is its cash flow.
"Cash and liquidity and cash flow determines whether a bank is safe or not," said Bove. "If the cash flow goes negative you are going down."
Don't trust the book value of capital
What did five firms — Bear Sterns, Washington Mutual, Lehman Brothers, Wachovia and Merrill Lynch — have in common?
They held a Tier 1 capital ratio between 12.3% and 16.1%, but still failed in 2008.
It's for that reason that Mark Flannery, Bank of America Professor of Finance at the University of Florida, made the case that an over-reliance on book capital (as regulators did prior to the crisis) is not the magic number that tells us whether banks can withstand a period of stress.
To make his point, he compared the book value of equity, market value of equity and credit-default spreads between 2004 and 2009 for the 19 largest U.S. banks, which are required to undertake stress testing by the Federal Reserve.
When it came to book value of equity, all banks stayed at the same threshold over the five-year period. Market-value, however, fell precipitously in the first quarter of 2008 from well-above book value to slightly below. CDS spread, which remained close to zero for most of that period jumped sharply at the same time and continued to be volatile through 2009.
The book numbers are "very sticky" and don't necessarily react to what's really happening, said Flannery. "It's better to maintain adequate market value of bank capital."
Boom times call for more capital
Of course, the real costs of higher capital ratios raise banks' overall cost of finance and end up making loans expensive. But that shouldn't stop banks from trying to raise capital during good times, so that they can stay afloat during the bad times.
Consider it a "good time capital requirement," says Samuel Hanson, an assistant professor of finance at the Harvard Business School. The IMF, he says, suggests that level should be around 7%. They best way to think about it: capital is "built up during good times" so banks can "eat through the losses during the down times," he said.
Too much capital = Too many unintended consequences
Not everyone agrees that capital is the answer, and bankers have their own reservations of what the impact will be with more capital requirements under Dodd-Frank and Basel III.
"You will see less lending," says Frank Sorrentino, chairman and CEO of North Jersey Community Bank. But, equally important will be the negative earnings impact, he says, which will make it harder to raise capital.
Not only that. Sorrentino argues that ultimately too much capital will end up hurting smaller-sized, community banks.
"If we're going to require higher capital standards, we're going to push some of these guys out of the system," said Sorrentino.