Oct 22, 2018

Is Your Bank Ready For The Next Crisis?

The campaign for financial deregulation should have you worried. Is bank supervision tight enough to prevent another meltdown? Is it loose enough to let the economy grow? The Trump Administration will tell you that it is scoring on both counts, but you may harbor doubts.

Here, we'll review what the regulators are up to, scorecard the biggest banks on a somewhat unconventional measure of safety and then take a look at a radical scheme to make the financial sector at once safer and freer.

Banks are more stable now than they were ten years ago, but they are not failproof. The usual way to measure the cushion against financial shocks compares shareholders' equity, the excess of assets like loans over liabilities like deposits, to assets. The table below takes a different approach, using market value in place of shareholders' equity. It captures the market's assessment of whether the assets are worth more or less than their book value. JP Morgan Chase is doing better than you thought, and Citigroup worse.

Bank safety has traditionally been a tug of war between regulators, who want the equity cushion to be fat, and bankers, who want to leverage as large a pile of earning assets atop that equity as they can. At a recent symposium hosted by the Manhattan Institute, Brent McIntosh, the U.S. Treasury's general counsel, described the government's lofty aims in this conflicted arena. Reform is underway, he said. Regulations will be light enough so that banks will have ample room for growth-fostering loans. But they will be tight enough so there won't be another round of taxpayer-funded bailouts.

Banks with less than $10 billion in assets are benefitting from deregulation already, with Trump's signature earlier this year on a bill that exempts them from the worst of Dodd-Frank, the statutory thicket inflicted on the financial sector as punishment for the 2008 crisis. But the impact of small banks on the economy is also small. The bulk of the country's deposit-taking and loan-making is done by larger banks. They remain encased in compliance costs.

The knottiest of the government's financial regulations is the Volcker Rule, a part of Dodd-Frank decreeing that banks may do trading in order to hedge or to service customers, but not to speculate. It is named after Paul Volcker, the two-meter-tall Fed chairman from 1979 to 1987.

Volcker's stature on Wall Street seems to be more a function of his height than his insights. Consider the task that bank examiners undertake when enforcing his rule: using formulas to divine a trader's motivation. But there's really no formula that will spell out whether a cluster of, say, 30 swaps, rate futures and short and long bond positions is on net speculative. You'd need a roomful of mathematicians to answer that question.

President Obama was a big admirer of the antitrading rule when it surfaced during his time in office. Bureaucrats love it. Outside the government, there are more skeptics. Lawrence White, a New York University professor, has called it "costly" and a "waste of effort."

Without a Volcker Rule, is there any way to keep bankers from shooting craps with depositors' money? There is. John Cochrane, an economist at the Hoover Institution, proposes that banking be divided in two. Safe banks would invest 100% of depositors' money in reserve funds at the Fed. Safe banks would supply the country with the mechanism to make transactions. They would be immune to depositor runs. They would pay meager interest rates.

All other bank investing in mortgages, business expansion, leveraged buyouts, trading, would be financed with equity. Savers would take their chances here. They'd own either common shares of the bank or, at lower risk but lower expected return, other securities, such as pieces of loan pools. They would have no right to withdraw anything. When they needed money, they'd sell their stakes at whatever prices they could get.

Equities are volatile. They make people richer or make them poorer. But they do not cause runs. They do not send the country's payment mechanism into a freeze.

Divided banking would engender a marvelous shrinking of government, since bank examinations could be limited to guarding against embezzlement. Between them the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation have 9,800 employees; most could be sent packing. So could a chunk of the Federal Reserve System staff.

Cochrane's theory is not purely academic. Recently some adventurers put together an entity they call TNB ("the narrow bank") that would stash all its deposits at the Federal Reserve. They got a state charter in Connecticut and asked the Federal Reserve Bank of New York to let them open an account there to hold TNB's money.

If the employees of the nation's central bank were doing their jobs, they would have welcomed a financial institution guaranteed to be safe from collapse. But maybe the folks at the Fed are more interested in protecting their jobs than doing them. FRBNY, acting (so alleges a lawsuit by TNB) at the behest of Federal Reserve panjandrums in Washington, rejected the application. God forbid TNBs catch on and make people like Paul Volcker less consequential.

The last has not been heard from this battle. Entrepreneurs may yet find a way to disrupt traditional deposit-taking and its huge compliance costs.

What about the other half of the equation, the 100% equity-financed, deposit-free bank? Could such a thing find any investors? Yes, indeed. There are a lot of all-equity banks out there, but you might not have noticed because they don't call themselves banks. They're funds.

The FlexShares Ready Access Variable Income ETF (ticker: RAVI) is one of these things. By dint of the securities in its portfolio it is lending money to such borrowers as Pfizer, the U.S. Treasury and Honda owners. The investors in this intermediary bear a low risk of rising interest rates (duration, per Morningstar, is half a year) and a moderate risk of default (average credit quality is BBB). Savers are willing to take these risks in order to get more yield than they could in an FDIC-insured checking account.

Another nonbank bank: iShares Short-Term Corporate Bond ETF (IGSB). It finances the activities of Anheuser-Busch, GE, Walmart and other borrowers. Default risk is a bit lower and rate risk a bit higher than on the FlexShares product.

Alongside these two are hundreds more mutual and exchange-traded funds, with trillions of dollars out on loan.

Savers can position themselves anywhere they want on the credit spectrum, from AAA funds with Ginnie Maes to junk funds with defaults looming. They can pick their duration. They can finance any amount of trading or leveraged buyouts. Or they can go the other way by owning only short-term Treasury bills, available in abundance. There is no role for bank examiners or deposit insurance here.

We've asked Brent McIntosh, the Treasury guy, about divided banking. His talk is about deregulation but his instincts are those of the deep state. "It's not one of the things we looked at," he said.