Maintaining Adequate Bank Capital
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1 Maintaining Adequate Bank Capital Mark J. Flannery Prepared for Bocconi University CAREFIN s Basilea 3 e la nuova definizione de capitale, December 2,
2 Buongiorno. Sono soddisfatto oggi di essere con voi. 2
3 25 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 3
4 Outline Bank Capital: Economic value of assets exceeding liabilities provides Loss Absorption Adequate: keep a large % of risk private; tail to government oernment 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 4
5 What is capital? (#1 of 3) Absorb b losses without t compromising i liabilities Questionable solvency is particularly burdensome for financialfirms firms. Run able claims are particularly important to protect. During the crisis, sub debt bore no losses. Subordinated ddbtd debt doesn t necessarily protect t run able claims because it requires an uncertain andtime consumingbankruptcy process. Only equity capital provides loss Only equity capital provides loss absorption without bankruptcy. 5
6 What is capital? (#2 of 3) Protection requires sufficient market valued or economic capital. Bear Stearns Washington Mutual failed in 8 Lehman Brothers Wachovia Tier 1 capital ratio Merrill Lynch was 12.3% 16.1% 6
7 What is capital? (#3 of 3) Liability holders are protected when the economic or market value of assets exceeds promised liability payments. Book valued capital Substantially backward looking Managerial discretion May not include bank s intangible charter value Market valued capital Forward looking Shares assessments with ST liability holders Includes charter value 7
8 What is adequate capital? (#1 of 2) Separates private from public (tail) riskbearing. The exact level is arbitrary The concept includes a time dimension. i A large bank operating with inadequate capital is extracting value from a conjectural government guarantee. 8
9 9
10 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. Morerapid rapid re capitalization requires a lower minimum capital level RPs Margin accounts Longer delay higher required cushion 10
11 Looking forward a bit: Contingent capital bonds shorten (and make more reliable) the interval between recognizing g that capital is inadequate and fixing the shortfall. 11
12 Outline Bank Capital: Economic value of assets exceeding liabilities provides Loss Absorption Adequate: keep a large % of risk private; tail to government oernment 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
13 Maintaining Adequate Capital (1) 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 8 FSA permitted Northern Rock to distribute excess capital a few weeks before it failed. Other Examples: 13
14 25 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 14
15 MV vs. BV of Equity Dt Dataset tof large US U.S. bank kholding companies 1986 II through 9 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% 7.17% 161% BUT as book values decline, they become upward biased, compared to market values. (Due to managerial discretion?) 15
16 Book vs. Market Equity Ratios, % 42% 21% 37% 16
17 20% 15% 10% 5% 0% Citigroup 4q1 4q2 4q3 4q4 5q1 5q2 5q3 5q4 6q1 6q2 6q3 6q4 7q1 7q2 7q3 7q4 8q1 8q2 8q3 8q4 9q1 9q2 9q3 9q4 Tier1/RWA MVEQ/BVA 17
18 20% BankAmerica 15% 10% 5% 0% 04q1 04q2 04q3 04q4 05q1 05q2 05q3 05q4 06q1 06q2 06q3 06q4 07q1 07q2 07q3 07q4 08q1 08q2 08q3 08q4 09q1 09q2 09q3 09q4 Tier1/RWA MVEQ/BVA 18
19 Citigroup Market/Book Equity to Total Assets META BETA Percentagee Points (%) 1986Q2 1987Q1 1987Q4 1988Q3 1989Q2 1990Q1 1990Q4 1991Q3 1992Q2 1993Q1 1993Q4 1994Q3 1995Q2 1996Q1 1996Q4 1997Q3 1998Q2 1999Q1 1999Q4 0Q3 1Q2 2Q1 2Q4 3Q3 4Q2 5Q1 5Q4 6Q3 7Q2 8Q1 8Q4 9Q3 19
20 20
21 In short, Basel s s focus on book values has often permitted market values to fall far below minimum required capital ratios. Forbearance has been a continuous problem. Extremely challenging gsupervisory task. We should not expect better supervision in the future. 21
22 Maintenance Failures TBTF TBTF has bad bdeffects on the financial i and real sectors. Financial crisis behavior made them effect worse. To avoid TBTF distortions, i either ih a) Assure that large banks never run out of private equity b) Design a stress less resolution mechanism. The practical choice is a). 22
23 Outline Bank Capital: Economic value of assets exceeding liabilities provides Loss Absorption Adequate: keep a large % of risk private; tail to government oernment 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
24 Policy Response So how can we be sure that TBTF firms don t run out of private 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. 24
25 One Possible CCB 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 Shareholders may suffer dilution Share price decline Change of control 25
26 Bank Capital Assets Liabilities Loans Deposits CDOs 50 5 Sub debt 10 Capital 7% capital ratio considered sound or adequate. (Basel 3) 26
27 Bad Things Can Happen to Banks Assets Liabilities X 49 X 47 Loans Deposits CDOs 50 5 Sub debt X 6 10 Capital Shareprice. Reduced credit quality higher default probability. 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
28 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 Debt CC bonds 10 Capital Now what happens when asset values fall? 28
29 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
30 Step 2: CC Bonds Convert Assets Liabilities Loans Deposits CDOs 47 5 CC Bonds X 0 X 6 11 Capital Bondholders are paidoff infull full. Supervisors and management have more time to work on the bank s problems. Bank becomes less likely to impose losses on taxpayers. 30
31 The (tax) Bargain Common Equity Vs. Contingent Common Common Equity Vs. Contingent Common 31
32 Policy Considerations 1. Required for SIFIs, permitted to others 2. Instrument design Trigger value Size of CCB tranche(s) h() CCB maturity structure Replacing converted bonds 3. Component of systemic or other buffers 4. Will reduce procyclicality 32
33 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 adequatecapital ratio. BUT the status quo also makes mistakes 1. Mostlylike like #1 above expensivefor taxpayers 2. TBTF distortions 33
34 Issuer Choices Conversion price Tranching Seniority structures among CCB Trigger height (above minimum) 34
35 Comparison to Bail in CCB Going concern Transparent market trigger Contractual No zombies Gone? Bail in Supervisory nonviability Legislated Bank can operate while insolvent gamble for resurrection Can be complementary. 35
36 Summary 1. Equity s market value protects bank liability holders and stabilizes bank operations. 2. TBTFoccurs becausebasel Basel based basedsupervisionsupervision has not regularly maintained adequate capital at large institutions (SIFIs). 3. Contingent capital with a market trigger prevents forbearance. 4. Conversion price near contemporaneous value makes convertible bonds investmentgrade grade. 5. Compared to holding more common equity, CCB area a good dealfor both bankersandtaxpayers and taxpayers. 36
37 37
38 35 30 Mean (Equity Measures, % of RWA) MV common 10 Tier Q Q Q Q11 0Q1 1Q11 2Q1 3Q1 4Q1 5Q1 6Q1 7Q1 8Q1 9Q1 38
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