HIGHER RESERVES ARE A LESS PAINFUL WAY TO FIX THE BANKS / THE FINANCIAL TIMES COMMENTARY & ANALYSIS

Higher reserves are a less painful way to fix the banks

Alan Greenspan

A gradual rise in capital requirements need not suppress earnings, writes Alan Greenspan

©AFP

 

 The US economy has just been through an unprecedented debilitating financial crisis and six years of economic stagnation. It did not have to turn out that way.

 

What the 2008 crisis exposed was a fragile underpinning of a highly leveraged financial system.

Had bank capital been adequate and fraud statutes been more vigorously enforced, the crisis would very likely have been a financial episode of only passing consequence.

 

If average bank capital in 2008 had been, say, 20 or even 30 per cent of assets (instead of the recent levels of 10 to 11 per cent), serial debt default contagion would arguably never have been triggered.

 

Had Bear Stearns and Lehman Brothers continued as capital-conscious partnerships, a paradigm under which both thrived, they would probably still be in business. The objection to a capital requirement of 20 per cent or more, even when phased in over a series of years, is that it will suppress bank earnings and lending. History, however, suggests otherwise.

 

In the US from 1870 to 2014, with rare exceptions, commercial bank net income as a percentage of equity capital ranged from 5 to 10 per cent annually. That rate edged modestly higher in the run-up to the crisis of 2008, presumably reflecting greater risk associated with a marked expansion in the legal scope of commercial bank powers.
 
Banks compete for equity capital against all other businesses. The ratio of after-tax profits to net worth for US nonfinancial corporations has, not surprisingly, also ranged from 5 to 10 per cent annually for nearly a century, and the earnings-price yield of US common stock has ranged from 5 to 13 per cent annually since 1890.

In the wake of banking crises over the decades, rates of return on bank equity dipped but soon returned to their narrow range. The sharp fall of 2009, for example, was reversed by 2011.

Minor dips more quickly restored net income to its stable historical range. In 2014, the rate was 8.7 per cent. The only significant exception occurred in the Great Depression. But even then, profit rates were back to 1929 levels by 1936.
 
What makes the stability of banks’ rate of return since 1870 especially striking is the fact that the ratio of equity capital to assets was undergoing a significant contraction followed by a modest recovery. Bank equity as a percentage of assets, for example, declined from 36 per cent in 1870 to 7 per cent in 1950 because of the consolidation of reserves and improvements in payment systems. Since then, the ratio has drifted up to today’s 11 per cent.

So if history is any guide, a gradual rise in regulatory capital requirements as a percentage of assets (in the context of a continued stable rate of return on equity capital) will not suppress phased-in earnings since bank net income as a percentage of assets will be competitively pressed higher, as it has been in the past, just enough to offset the costs of higher equity requirements. Loan-to-deposit interest rate spreads will widen and/or non-interest earnings will increase. An important collateral pay-off for higher equity in the years ahead could be a significant reduction in bank supervision and regulation.

 

Lawmakers and regulators, given elevated capital buffers, need to be far less concerned about the quality of the banks’ loan and securities portfolios since any losses would be absorbed by shareholders, not taxpayers. This would enable the Dodd-Frank Act on financial regulation of 2010 to be shelved, ending its potential to distort the markets — a potential seen in the recent decline in market liquidity and flexibility.

 

Well-capitalised banks need to be less fettered in their primary economic function: to assist in the directing of the nation’s scarce savings to fund our most potentially productive investments. Funding cutting-edge capital investments will engender growth in national productivity and standards of living.


The writer is a former chairman of the US Federal Reserve