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Good News for America, Bad News for Banks

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Wall Street bankers make millions of dollars a year, many (many) multiples of what the average Joe makes. And when they screw up -- big time, I might add -- taxpayers like Average Joe combine their relatively paltry earnings to bail them out.

This is ironic, of course, because when Average Joe screws up, he's summarily fired by the very same people that he bailed out -- thank you, private equity industry for showing us that it's OK to profit off the misery of others. But I digress.

Do you like this narrative?

If not, then you'll be happy to hear that nation's primary banking regulators have decided to make it slightly less likely to happen again.

Earlier this week, the Federal Reserve, Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency proposed to increase in the so-called leverage ratio of the nation's largest banks. This ratio compares the amount of capital that banks like JPMorgan Chase (NYSE: JPM  ) and Citigroup (NYSE: C  ) must hold against their assets.

The newly minted international standard, known as Basel III, pegs the ratio at 3%. Meanwhile, our regulators, in all their recently renewed glory, believe that banks should be required to hold capital equivalent to 5% of their assets -- and 6% if the bank is characterized as a systematically important financial institution, as are the two above, as well as Bank of America (NYSE: BAC  ) and Wells Fargo (NYSE: WFC  )  and others.

Despite all of the squealing that's erupted on Wall Street claiming that the higher floor will "make the U.S. banks a little less competitive, a little less profitable," there's no question that this is a positive development for the country.

Sure, when times are good, it's great to run a bank like you would a highly leveraged hedge fund -- though to be fair to hedge funds, most are too savvy and risk averse to use the quantity of leverage that banks employ. This juices return on equity and, more importantly, executive compensation.

But when money gets tight, as it did in 2007 and 2008, the downside is equally dramatic, as high leverage leaves little capital to absorb losses from the comparatively massive asset portfolios. My colleague Morgan Housel discussed how this factored into the fall of Lehman Brothers.

The key to Lehman's failure was, of course, leverage. At the end of 2007, leverage stood at more than 30-to-1, with $22 billion of equity supporting $691 billion in assets. The mechanics of such leverage is nauseating: A little more than a 3% decline in asset values, and it's game over. Anyone with a handle on fifth-grade arithmetic gets this, and the pre-Lehman leveraged failures of Long-Term Capital Management and Bear Stearns reiterated its cruelty. Name one bank that's flourished long-term on gross leverage, and you'll find thousands that met a quick death. It just doesn't work.

Now, as I noted above, there is another side to this story, and that side is the banks'. Despite accumulating massive amounts of capital over the last few years, most of the nation's largest lenders are still behind in terms of the newly proposed standards.

According to an analysis by The Wall Street Journal, JPMorgan, Citigroup, Morgan Stanley, and Goldman Sachs (NYSE: GS  ) will all have to increase their capital bases -- presumably through the retention of earnings. By comparison, both Bank of America and Wells Fargo already have more than enough capital accumulated to meet the proposed increase.

And, as a Bloomberg News story pointed out, this does have significance for shareholders. "The biggest U.S. banks, after years of building equity, may continue hoarding profits instead of boosting dividends," the lede asserts.

At the end of the day, there are two critical points that should be kept in mind, here. First, even at 6%, banks will still be able to leverage up by a factor of nearly 17 to 1 -- think about that for a second: 17 to 1. And second, while there is little question that dividend growth may be throttled for the time being, anyone who claims this is bad clearly failed to learn the lesson of the last five years: With less capital, banks fail. And when banks fail, investors lose all of their money.

So, sure, this might be bad for the already unconscionable salaries of Wall Street executives. But it's unquestionably good for America.

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  • Report this Comment On July 11, 2013, at 9:16 AM, fredricjl wrote:

    The real problem is not with bank capital but with the risk inherent in the investments available. Subprime, zero down, interest only etc loans and all their subcategories are the problem. Also a meddling government insisting the banks lend to deadbeats. The part of this article that points out the people at the top make outrageous paydays regardless of the outcome is also something that needs fixing. They should be required to take their "excess" pay through a fund that invests solely in company common stock that is never redeemable and only pays out income. That would eliminate all of the risk.

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