Surplus capital is not for wimps after all

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John explains why capital is the stuff you have to protect yourself and why banks can never have enough of it.

Can a bank have too much capital? To the person in the street, the answer is obvious. The function of a bank is to seek out profitable investment and lending opportunities. The more capital it has to hand, the more successful it will be.

To a professor of finance, the answer is also obvious. The professor will refer to the Modigliani-Miller theorem, which states that the value of a business is independent of its capital structure. It follows that a bank cannot add value for shareholders by altering the proportions of debt and equity in its balance sheet.

There are, however, many people who know more than the man in the street but less than the professor of finance. These people talk of surplus, or even dead, capital. One consequence of the Basel agreements on capital requirements for financial institutions is that many of these institutions came to believe it was wimpish to hold more capital than the regulations demanded. There were superficially appealing financial arguments to justify that position. Surplus capital reduces return on shareholders’ equity and acts as a drag on earnings per share. Analysts judge banks by these ratios. The rewards of senior executives were often tied to them.

A bank might sell some branches, assisting the purchaser with a non-recourse loan, for which the borrower is not personally liable. At current rent levels and interest rates, the rent would service the debt. The financial effect of the transaction is that any future capital gain on the property is transferred from the bank to the buyer. At the same time, the capital base of the bank is reduced, impairing the security of depositors and lenders. But reducing capital is the point – the only point – of the transaction. Since the yield on property is less than the bank’s return on equity, the return on equity is increased.

I am not making this up. The executives who planned this and similar transactions were applauded for their financial acumen and focus on shareholder value. You can raise return on capital by increasing returns or by reducing capital. Reducing capital is easier. Such financial alchemy does not just apply to banks. You can increase earnings per share by increasing earnings or by reducing the number of shares. Reducing the number of shares is easier.

The professor of finance can quickly pinpoint the fallacy in the surplus capital argument. Debt is cheaper than equity. But the cost of both debt and equity depends on their riskiness. Increasing the ratio of debt to equity makes both debt and equity riskier and raises their costs. So the gain from substituting debt for equity must be offset against the loss from increasing the long-run cost of both debt and equity. In an article that is still a classic of finance theory, Merton Miller and Franco Modigliani showed, 50 years ago, that in an efficient market the loss would exactly offset the gain.

There are a few complications. In particular, markets are not always efficient. But prices tend to revert to fundamental value in the long run. The mispricing of risk eventually reveals itself. As it has just done.

Banks would normally be wary of lending to someone whose liabilities were 50 times their net assets, but they happily lent to each other on that basis – until, one day, they stopped. If you want a one sentence explanation of the present crisis, that is it.

In business, capital is the stuff you have to protect yourself, your customers and your creditors when things go wrong. In good times, you may feel you do not need it and may resent paying for it. In bad times, you can never have enough. If you do not have it already you will find it very expensive or impossible to obtain. You may then go broke. If you want a one paragraph explanation of the capitalist system, that is it.

It is reassuring that both financial economics and practical wisdom point to the same conclusions. Banks have come to the verge of collapse because they did not have enough capital to support their modern business model. There is no such thing as a bank with too much money.

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