Banking is fundamentally a simple business. Banks access funds and lend them out. If fees and expenses are properly managed, a bank's ability to leverage its equity capital should result in a satisfactory return for shareholders.
However, managing a bank, as an institutional investor once said, is "like landing a plane on an aircraft carrier — there is only one way to do it right and a lot of ways to do it wrong." Unfortunately, a lot of banks recently missed the carrier deck.
Without a healthy banking industry, there will be few loans to fund the recovery. Banks' access to capital which they leverage and lend will be limited until the capital markets reacquire confidence in the industry. Funds from the Troubled Asset Relief Program are an inadequate substitute for vibrant capital markets.
Three factors contributed to the gridlock seizing the banking industry: market efficiencies, changing accounting rules, and tighter capital standards.
Over the last 25 years the industry has become more efficient. Interstate banking, interindustry mergers, and expanded operating powers and product offerings have made the industry more competitive while putting pressure on profitability. In response, many banks trimmed their cost base, took on riskier businesses, or simply sold out or merged with larger, more adept institutions.
Simultaneously, accounting rules changed. Investors' desire for financial transparency led to fair-value accounting standards. Not only did banks find it difficult to meet this standard, but the writedowns of troubled assets depleted their capital base.
Another accounting change caused disproportionate harm to merging banks: the elimination of pooling-of-interests merger accounting.
Historically, companies could generally account for their transactions using either pooling or purchase accounting standards. Pooling was utilized in over 80% of bank mergers, because the acquiring entity's balance sheet would book no goodwill (the difference between the purchase price and the net asset value of the acquired institution). For banks, goodwill is "bad," simply because regulators do not recognize it as a qualifying asset in the calculation of minimum capital standards.
The pooling accounting option was eliminated in 2001. The accounting standard was not specific to the banking industry, but the repercussions there far exceeded those in nonregulated industries, where goodwill was not considered bad.
Bank capital standards have increased over the last 20 years to protect depositors and investors and to conform to international standards. One trend has been to eliminate goodwill as a qualifying asset in the calculation of minimum capital standards as regulators moved toward a tangible asset test for capital standards.
However, accounting rules permit the recording of goodwill on balance sheets unless it is deemed impaired. At least for some, it truly has value, and perhaps it is not so bad.
Given these factors, how do we restore the health of the banking industry? There is no way to alter the market forces that shaped the industry. The fair-value accounting genie is out of the bottle. However, we can re-evaluate the amount of goodwill that regulators permit as qualifying assets in bank capital standards.
The industry has booked over $300 billion of goodwill — an amount almost equal to the Tarp funds accepted by banks. Some of the most troubled institutions have enormous amounts of goodwill. Bank of America carries $82 billion, and Citigroup carries $37 billion. Though the accounting industry allows such assets to be capitalized, bank regulators effectively assign them zero value. How can two authorities differ so significantly on the value of an asset class?
Here is my proposal: First, direct the regulatory authorities to declare that for the next five years banks will be able to use up to 50% of their capitalized goodwill as a capital-qualifying asset. At the conclusion of the five-year period, regulators would re-evaluate the policies, and the regulations could revert to existing standards.
Second, incent banks to purge their balance sheets of toxic assets by allowing additional amounts of capitalized goodwill as capital-qualifying assets. For example, for every $20 of problem assets removed from its balance sheet, a bank would be able to use $1 of capitalized goodwill as a capital-qualifying asset.
Consider the proposal's implications. It is simple and straightforward. A complicated solution built on an already-complex system is doomed to abuse and mismanagement, as we experienced with Tarp. Also, the proposal does not spend taxpayer dollars, unlike Tarp, and it would allow market mechanisms to work. Once banks rehabilitate their balance sheets, they would be rewarded with higher market valuations and improved access to capital markets. Importantly, the proposal relieves the government of the task of managing private-sector banks.
In addition, the proposal can be implemented quickly and simply by changing the applicable regulatory capital standards. Banks already have significant restorative capital on their balance sheets. The regulatory standards should be modified temporarily to utilize it.
Is this a perfect solution? Hardly. Critics will suggest that it dilutes improved capital standards, provides leniency, and is oblivious to the complexities of measuring risk at precisely the time when we need such controls. However, the proposal is actually a complement to the implementation of stricter bank regulations once the industry's health is restored.
It is imperative that we implement an efficient and effective means to cure our banking crisis. Our economy will not gain traction until banks fund our recovery and growth. Those funds will not flow until banks are restored to health and have secured the confidence of capital markets. Once these events occur and we put the recession behind us, the banking industry will thrive.
Only then will bank managers have the opportunity to get back to the simple business of banking and find a way to land the plane safely on the carrier deck.