Simon Johnson: U.S. Banks Need More Capital

The Vickers report came out in Britain identifying areas where Britain’s banking system needed to alter its regulatory structure. Simon Johnson talked to Bloomberg about this report and banking regulation in general. His view is that first and foremost large globe-spanning banks are too large. Using Goldman Sachs as an example, he notes that Goldman had a $1 trillion balance sheet when the panic hit in 2008, 4 times as many assets as it did just a decade earlier. Meanwhile most studies show no significant economies of scale or scope above the $300 billion range.

On the UK in particular, Johnson notes that the UK has the Icelandic problem, meaning that its financial sector is very large relative to the size of its economy – five or six times the size of GDP. In Iceland, this was catastrophic, resulting in the failure of its three largest banks and an economic depression. In Ireland, the result was equally disastrous as the four largest banks were rescued by the federal government at great cost to taxpayers. National bankruptcy is an unfortunate possibility. This issue was very talked about in late 2008 and early 2009 (see Iceland: a cautionary tale for small nations and Too big to rescue). However, since then, people have acted as if these concerns are irrelevant. But, Johnson argues that herding by banks means that a nation’s big banks all face similar risks such that when one gets into trouble they all feel the same stress to their balance sheet.

Johnson believes a 25% equity financing level is the right amount. That would give banks four-to-one leverage (discounting the embedded leverage of derivatives, of course). He also believes this ratio should be pro-cyclical, meaning equity capital should increase as the economy improves to provide a buffer against the pro-cyclicality of the credit cycle in which dodgier loans are made at the top of the cycle.

Video below.

5 Comments
  1. Ebipere Clark says

    Equity is pro-cyclical?
    Wow! That is going to be a tough one to sell to.
    The bank lobby guys are going to love that one.

    Ed – Here is my option – keeping it simple, very simple.

    ALL banks’ debt (at all maturities) should be puttable into equity at given levels of share-price.
    Clearly the shorter-term the debt the less-likely it is to be triggered into equity – for a given share price.
    The level of exercise would determine the seniority of the debt.

    This would mean that the lender is intrinsically and explicitly short a downside put when she lends money to the bank.
    The lender then has the option of whether she goes into the equity derivatives market to cover this put or simply enjoys the ‘additional yield’ of the put premium which she synthetically receives in the interest rate.
    Expect banks borrow costs to rise to pay for this put – not a bad thing.

    There is no nonsense about rolling over debt – if the banks shares have collapsed at maturity the lender gets shares (a currency that the bank controls) rather than cash (a currency that the bank does not).
    Effectively the debt acts as a ‘reverse-convertible’.

    You now have linked the downside equity derivatives market with the (downside) credit derivatives market.
    One is triggered by share price – the other by credit events – an “arbitrager’s wet dream”

    Who owns the (embedded) put?
    Actually there is a good case for the bank regulator owning, or triggering, it. However, it should be triggered simply by share price not bank equity nor capital limits – let the market play silly buggers at the ‘strike price’.

    No need for government to back-stop creditors now: debt will turn to equity exactly when it is needed.

    1. Edward Harrison says

      Contingent capital is a good option to consider. Some of the potential hazards include people monkeying around with credit default swaps, the effect of the put in accelerating a share collapse, etc.

      Yves Smith had some pushback a few days ago on CoCos. Here’s the write-up:

      http://www.nakedcapitalism.com/2011/04/a-suspicious-sniff-at-cocos.html

      But I agree with you that 25% average capital over the cycle is going to be a tough sell. Still, note that the Swiss are moving to 19% average, no pro-cyclicality, so that’s a benchmark.

      1. Ebipere Clark says

        Thank you – it is a good article but I think that it is still not simple enough.

        Contingent Capital/Convertibility has flaws (or features) that many can and will gripe about. However with the level of “Financialisation” of The Economy and what we have experienced over the past 4 years, the ability to have an automated/automatic fail-safe is beyond-necessary.

        It is rather like complaining about seat-belts, crumple-zones, and air-bags.

  2. Ebipere Clark says

    Equity is pro-cyclical?
    Wow! That is going to be a tough one to sell to.
    The bank lobby guys are going to love that one.

    Ed – Here is my option – keeping it simple, very simple.

    ALL banks’ debt (at all maturities) should be puttable into equity at given levels of share-price.
    Clearly the shorter-term the debt the less-likely it is to be triggered into equity – for a given share price.
    The level of exercise would determine the seniority of the debt.

    This would mean that the lender is intrinsically and explicitly short a downside put when she lends money to the bank.
    The lender then has the option of whether she goes into the equity derivatives market to cover this put or simply enjoys the ‘additional yield’ of the put premium which she synthetically receives in the interest rate.
    Expect banks borrow costs to rise to pay for this put – not a bad thing.

    There is no nonsense about rolling over debt – if the banks shares have collapsed at maturity the lender gets shares (a currency that the bank controls) rather than cash (a currency that the bank does not).
    Effectively the debt acts as a ‘reverse-convertible’.

    You now have linked the downside equity derivatives market with the (downside) credit derivatives market.
    One is triggered by share price – the other by credit events – an “arbitrager’s wet dream”

    Who owns the (embedded) put?
    Actually there is a good case for the bank regulator owning, or triggering, it. However, it should be triggered simply by share price not bank equity nor capital limits – let the market play silly buggers at the ‘strike price’.

    No need for government to back-stop creditors now: debt will turn to equity exactly when it is needed.

    1. Edward Harrison says

      Contingent capital is a good option to consider. Some of the potential hazards include people monkeying around with credit default swaps, the effect of the put in accelerating a share collapse, etc.

      Yves Smith had some pushback a few days ago on CoCos. Here’s the write-up:

      http://www.nakedcapitalism.com/2011/04/a-suspicious-sniff-at-cocos.html

      But I agree with you that 25% average capital over the cycle is going to be a tough sell. Still, note that the Swiss are moving to 19% average, no pro-cyclicality, so that’s a benchmark.

      1. Ebipere Clark says

        Thank you – it is a good article but I think that it is still not simple enough.

        Contingent Capital/Convertibility has flaws (or features) that many can and will gripe about. However with the level of “Financialisation” of The Economy and what we have experienced over the past 4 years, the ability to have an automated/automatic fail-safe is beyond-necessary.

        It is rather like complaining about seat-belts, crumple-zones, and air-bags.

  3. Blankfiend says

    Evidently, Jamie Dimon does not agree. Increasing the dividend and announcing a 15 BN share buyback program.

    1. Ebipere Clark says

      Well he has every right to.
      Incredible – how Geithner and Bernanke can even walk in public without being lynched is beyond me. What a heist!

  4. Blankfiend says

    Evidently, Jamie Dimon does not agree. Increasing the dividend and announcing a 15 BN share buyback program.

    1. Ebipere Clark says

      Well he has every right to.
      Incredible – how Geithner and Bernanke can even walk in public without being lynched is beyond me. What a heist!

Comments are closed.

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