Keeping Capital Adequate

Transcription

1 Keeping Capital Adequate Mark J. Flannery University of Florida Prepared for the Nykredit Symposium 2010, Financial Stability and Future Financial Regulation, December 13, Figure 1: Market and Accounting Metrics for SCAP Firms 400 % bps 0 1Q04 1Q05 1Q06 1Q07 1Q08 1Q09 Market Value of Equity / Assets (left) Book Value of Equity / Assets (left) CDS Spread (right) Notes: Market value and book value ratios are simple means for 18 FIs that participated in the SCAP, excluding GMAC. CDS spreads are simple means of available data. Source: Kevin Stiroh, FRB NY 0 2 1

2 Outline Bank Capital: Economic value of assets exceeding liabilities provides Loss Absorption. Adequate: keep a large % of risk private; tail to government. Maintaining: Basel s capital based regulation has not reliably maintained large banks capital high enough to guarantee their solvency. A Good Solution: contingent capital bonds (CCB) convert to equity when needed to de lever going concern conversion triggered by a market valued equity ratio 3 What is capital? (#1 of 4) Absorb losses without compromising liabilities Questionable solvency is particularly burdensome for financial firms. Run able claims are particularly important to protect. During the crisis, sub debt bore no losses. Subordinated debt doesn t necessarily protect run able claims because it requires an uncertain and time consuming bankruptcy process. 4 2

3 What is capital? (#2 of 4) has provided Only equity capital provides loss absorption without bankruptcy. New resolution mechanisms: Loss absorbing regulatory capital instruments Bail in See below. 5 What is capital? (#3 of 4) Protection requires sufficient market valued or economic capital. Bear Stearns Washington Mutual Lehman Brothers Wachovia Merrill Lynch failed in 2008 Tier 1 capital ratios were 12.3% 16.1% 6 3

4 What is capital? (#4 of 4) Liability holders are protected when the economic or marketvalue of assetsexceeds exceeds promised liability payments. Book valued capital Substantially backward looking Managerial discretion; accounting rules Regulators may exclude/limit intangibles Market valued capital Forward looking Shares assessments with ST liability holders Includes all valuable intangibles 7 What is adequate capital? (#1 of 2) Separates private from public (tail) riskbearing. The exact level is arbitrary The concept includes a time dimension. A large bank operating with inadequate capital is subsidized via a conjectural government guarantee. 8 4

5 9 Adequate Capital (#2 of 2) Unlike a fixed pool, banks can add more equity if they suffer losses. Banks need to maintain enough equity cushion to preserve solvency until new equity can be sold. More rapid re capitalization requires a lower minimum i capital level l Repos Margin accounts Longer delay higher required cushion 10 5

6 Forbearance is a subsidy shifts risk to taxpayers. Looking forward a bit: Contingent capital bonds shorten (and make more reliable) the interval between recognizing that capital is inadequate and fixing the shortfall. 11 Outline Bank Capital: Economic value of assets exceeding liabilities provides Loss Absorption Adequate: keep a large % of risk private; tail to government Maintaining: Basel s capital based regulation has not reliably maintained large banks capital high enough to guarantee their solvency. A Good Solution: contingent capital bonds (CCB) convert to equity when needed to de lever going concern conversion triggered by a market valued equity ratio 12 6

7 Maintaining Adequate Capital Basel specifies consequences if regulatory (book) capital falls, but not if the firm s true loss absorption capacity falls. For example, during the crisis U.S. did not prevent dividends, even in 2008 FSA permitted Northern Rock to distribute excess capital a few weeks before it failed in Other examples, to come Figure 1: Market and Accounting Metrics for SCAP Firms 400 % bps 0 1Q04 1Q05 1Q06 1Q07 1Q08 1Q09 Market Value of Equity / Assets (left) Book Value of Equity / Assets (left) CDS Spread (right) Notes: Market value and book value ratios are simple means for 18 FIs that participated in the SCAP, excluding GMAC. CDS spreads are simple means of available data. Source: Kevin Stiroh, FRB NY

8 MV vs. BV of Equity Dataset of large U.S. bank holding companies 1986 II through 2009 IV Exclude hi cap credit card banks. MVEQ >> BVEQ, on average MVEQ/TA BVEQ/TA MVEQ/BVEQ Mean 13.36% 7.36% 174% Median 11.94% 717% 7.17% 161% BUT as book values decline, they become upward biased, compared to market values. (Due to managerial discretion?) 15 Book vs. Market Equity Ratios, % 42% 21% 37% 16 8

9 9 15% 20% Citigroup 0% 5% 10% 2004q1 2004q2 2004q3 2004q4 2005q1 2005q2 2005q3 2005q4 2006q1 2006q2 2006q3 2006q4 2007q1 2007q2 2007q3 2007q4 2008q1 2008q2 2008q3 2008q4 2009q1 2009q2 2009q3 2009q4 Tier1/RWA MVEQ/BVA 17 20% BankAmerica 5% 10% 15% 0% 2004q1 2004q2 2004q3 2004q4 2005q1 2005q2 2005q3 2005q4 2006q1 2006q2 2006q3 2006q4 2007q1 2007q2 2007q3 2007q4 2008q1 2008q2 2008q3 2008q4 2009q1 2009q2 2009q3 2009q4 Tier1/RWA MVEQ/BVA 18

10 35 Citigroup Market/Book Equity to Total Assets Percentage Points (%) META BETA Q2 1987Q1 1987Q4 1988Q3 1989Q2 1990Q1 1990Q4 1991Q3 1992Q2 1993Q1 1993Q4 1994Q3 1995Q2 1996Q1 1996Q4 1997Q3 1998Q2 1999Q1 1999Q4 2000Q3 2001Q2 2002Q1 2002Q4 2003Q3 2004Q2 2005Q1 2005Q4 2006Q3 2007Q2 2008Q1 2008Q4 2009Q

11 In short, Basel s focus on book values has often permitted market values to fall far below minimum required capital ratios. Forbearance has been a repeated problem. Extremely challenging supervisory task. We should not expect better supervision in the future. 21 Maintenance Failures TBTF TBTF has bad effects on the financial and real sectors. Financial crisis behavior made them effect worse. To avoid TBTF distortions, either a) Assure that large banks never run out of private equity b) Design a stress less resolution mechanism. The practical choice is a)

12 Outline Bank Capital: Economic value of assets exceeding liabilities provides Loss Absorption Adequate: keep a large % of risk private; tail to government Maintaining: Basel s capital based regulation has not reliably maintained large banks capital high enough to guarantee their solvency. A Good Solution: contingent capital bonds (CCB) convert to equity when needed to de lever going concern conversion triggered by a market valued equity ratio 23 Policy Response So how can we be sure that TBTF firms don t run out ofprivate equity? No guarantees, but CCB with MV trigger can restrain supervisory forbearance. Pre arrange a bank s de levering Adequate capital restored more quickly Lower minimum capital ratio provides sufficient solvency protection. Book valued trigger may be (deliberately) too noisy to rely on

13 A Good CCB (CoCo) Structure Issued as debt Converts to shares if MVEQ ratio falls too low Conversion price share price at trigger Bondholders repaid in full No death spiral High (g ( going concern ) g trigger Shareholders may suffer dilution Share price decline Change of control 25 Bank Capital Assets Liabilities Loans Deposits CDOs 50 5 Sub debt 10 Capital 7% capital ratio considered sound or adequate. (Basel 3) 26 13

14 Bad Things Can Happen to Banks Assets Liabilities X 49 X 47 Loans Deposits CDOs 50 5 Sub debt 10 X 6 Capital Share price. Rd Reduced dcredit quality higher h df default probability. bilit Even if runs are not imminent, the bank has too high a failure probability. Bank s capital is inadequate < 7% Supervisory action required to restore adequate capitalization. 27 Contingent Capital Bonds Go back to before the bank s assets fell. Set up its liabilities differently. Assets Liabilities Loans Deposits CDOs 50 5 Sub CC bonds Debt 10 Capital Now what happens when asset values fall? 28 14

15 Step 1: Capital Value Falls Assets Liabilities X 49 X 47 Loans Deposits CDOs 50 5 CC Bonds X 6 10 Capital Capital is now inadequate (< 7%). 29 Step 2: CC Bonds Convert Assets Liabilities Loans Deposits CDOs 47 X5 0 CC Bonds X6 11 Capital Bondholders are paid off in full. Supervisors and management have more time to work on the bank s problems. Bank becomes less likely to impose losses on taxpayers

16 The (tax) Bargain Common Equity Vs. Contingent Common Common Equity Vs. Contingent t Common 31 Policy Considerations 1. Required for SIFIs, permitted to others 2. Instrument design Trigger value Size of CCB tranche(s) CCB maturity structure Replacing converted bonds Some issuer choice 3. Component of systemic or other buffers 4. Will reduce procyclicality 5. Better than simply raising required capital ratio

17 Is it perfect? Of course not. 1. Could fail to trigger at a needy bank 2. Could trigger at a bank that doesn t really need more equity 3. Converted tranche(s) could be too small to restore adequate capital ratio. BUT the status quo also makes mistakes 1. Mostly like #1 above expensive for taxpayers 2. TBTF distortions CoCos as deferred compensation 33 Comparison to Bail in CCB Going concern Transparent market trigger Prevent runs Contractual No zombies Gone? Bail in Supervisory nonviability Runs as trigger? Legislated Bank can operate while insolvent gamble for resurrection Can be complementary

18 Summary 1. Equity s market value protects bank liability holders and stabilizes bank operations. 2. TBTF occurs because Basel based supervision has not regularly maintained adequate capital at large institutions (SIFIs). 3. Contingent capital with a high market trigger prevents forbearance. 4. Conversion price near contemporaneous value makes convertible bonds investment grade. 5. Compared to holding more common equity, CCB are a good deal for both bankers and taxpayers. 35 Final Conclusion If a market valued conversion trigger won t work, contingent capital offers no real improvement over the status quo

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20 Probably remove this slide!!! Buongiorno. Sono soddisfatto oggi di essere con voi

21 35 30 Mean (Equity Measures, % of RWA) MV common Tier Q1 1997Q1 1998Q1 1999Q1 2000Q1 2001Q1 2002Q1 2003Q1 2004Q1 2005Q1 2006Q1 2007Q1 2008Q1 2009Q1 41 Issuer Choices Conversion price Tranching Seniority structures among CCB Trigger height (above minimum) 42 21