Bank Capital and the law of unintended consequences

Economists make much use of the term “Law of Unintended Consequences”. In brief, unintended consequences are outcomes that are not (or not limited to) what the actor intended in a particular situation. The unintended results may be foreseen or unforeseen, but they should be the logical or likely results of the action.

There have been a lot of arguments lately that a lot of the factors that led to the subprime crisis have been unintended consequences of well-intentioned government policies and regulations. For example, Economist’s View links to this argument that summarizes how the repeal of the Glass-Steagall act, the Bush tax cuts, and the low Federal funds rate have led to the current financial crisis.

Building on a previous post I had on Basel capital adequacy standards, I’d like to add that this well-intentioned set of international standards also contributed indirectly to the current mess. Basel standards recommends banks to have at least a 10% capital-to-risky assets ratio. That means, a bank needs to have at least 10% as much in capital as the amount of risky assets it invests in. By risky assets, we mean all bank lending and investments in risk-weighted assets. By capital, we mean equity capital, and in no way includes funds coming from bank deposits or bank borrowings.

Generally, the riskier an investment is, the more risk-weight it is given by Basel. A credit-grade mortgage loan will be given 50% risk weight, while a credit-grade regular consumer or corporate loan will be risk-weighted at 10%. Only investments in relatively risk-free government securities are given zero risk weight. That means, the more a bank allocates its funds to risk-weighted loans, the more it needs to have in equity capital. The more loans in a bank’s books, the higher its equity capital needs to be to maintain a capital ratio deemed adequate by Basel standards.

But raising bank equity does not happen in a vacuum. Just because a bank has sufficiently high deposits to loan out doesn’t mean shareholders will be flocking to provide it with new capital. To attract these investors, the bank would have to provide a comparable return to other investment alternatives. But to maintain the capital adequacy, the bank would have to redeploy this equity capital in low risk weight assets.

Government securities have zero risk weight, but in the environment of low Fed funds rate, the liquidity that resulted ensured that government securities provided meagre yield. Certainly not enough to increase bank earnings sufficient to attract new equity holders. So a good number of banks and insurance firms chose to put these funds into the asset class available at the time that had the next to lowest risk weight , AAA-rated CDO bonds.

Of course, the fact that these toxic CDOs made up of sub-prime loans were ever rated AAA by ratings agencies has already been widely discussed in public forums. But the fact is, banks and insurance firms, compelled by international best standards to maintain adequate equity cover, for loans in the case of banks, or for cover liabilities in the case of insurance firms, but also compelled by equity holders to provide the highest possible yield at reasonable risk, investing in AAA-rated CDOs seemed like a reasonable thing to do. Granted, much more due diligence should have been done on the underlying assets backing up these securities, but then, the presence of a rating meant that reasonable due diligence had already been done by experts on these matters.

So here we are, with banks loaded up with toxic securities, and no willing market to buy them out. At least, nowhere close to what the banks think they should be worth. With no willing market, the reasonable value for these securities should be what they would fetch for, as Bernanke called it, “firesale prices”.

No bank would of course unload them at firesale prices when they in fact could hold on to them up to maturity, and earn a much higher yield. By how much more, nobody will know til maturity. But given the inevitability of equity writedowns a firesale will result to, holding on is the more rational choice to do.

A consequence of course, is the loss of credibility of banks among each other. No bank will lend to another bank that can, at an instant, need to liquidate at firesale prices, and default on its borrowings as a result.

Suggested modifications to the “Paulson-Bernanke plan” have included making bank shareholders pay the penalty for the sins of the banks in creating the current mess. This is reasonable given that taxpayers will be footing the bill of the bailout, and they had nothing to do with messing up the financial markets.

But an unintended consequence of wiping out all existing shareholders of the banks is that unless the government’s capital injection is sufficient to provide adequate capital cover, these banks will have to operate either at sub-standard capital ratios, or start providing loans at more prohibitive rates, to earn back their lost capital.