Randall J. Pozdena

English

Research Papers in Economics

FRBSF WEEKLY LETTER
March 8, 1991
Recapitalizing the Banking System
The banking safety net has allowed banks
and thrifts to operate with little (and sometimes,
negative) net worth before authorities intervene.
Consequently, the claims on the insurance fund
tend to be large, and the premia necessary to
finance this fund correspondingly large even
in good times.
An alternative to maintaining a large insurance
fund is to increase the capital requirements for
insured banks. However, bankers argue that
capital is "too expensive;' and that higher
requirements would compromise their com-
petitive vigor. Others argue that "now is not
the time" to raise capital requirements.
This V/eekly Letter offers the case for increased
capital requirements as a means of reforming the
banking safety net. A system of higher capital re-
quirements will be no more costly to banks than
one that relies on low capital and a big insurance
fund with high premia. It offers the advantage,
however, of putting the greatest burden of reform
on banks exploiting the safety net.
The role of bank capital
The role of capital in an insured bank is to
provide a "cushion" that protects the insur-
ance fund (and other uninsured liability holders)
from decreases in the value of the bank's assets.
Options theory reveals that the expected claim
on the insurance fund with banks at a 15 percent
capital/asset ratio is 60 times smaller than at a 1
percent ratio. Just as importantly, higher capital
requirements reduce the value to the bank of
deposit insurance coverage and, hence, the
incremental benefit of risk-taking at the expense
of the safety net.
But would not higher capital requirements
increase bank costs? The answer is that they need
not. Indeed, were it not for distortions introduced
by tax policy and the deposit insurance system
itself, banks likely would prefer to hold far more
capital than they do today. To see this point, it is
necessary to understand a bit of finance theory.
Banks, like other firms, finance their assets
with a mixture of equity and debt (mainly
deposit debt). A famous theorem in finance
known as the Modigliani-Miller (M-M) irrele-
vance proposition says that the value of a firm
(or a bank) should be unaffected by its financial
structure, in the absence of any market imper-
fections. By implication, the market would
charge the same, on the margin, for a bank's
debt or for its equity.
If there are market imperfections, the M-M
proposition may not hold, causing banks to
prefer either debt or equity. For example, dead-
weight costs to bankruptcy (legal fees, losses
on sales of assets, etc.) would produce a bias in
favor of equity. This is because equity protects
against bankruptcy and, hence, the deadweight
costs it imposes. Leland and Pyle have argued
that a bank's owners may hold more equity to
signal to bank depositors that they have faith in
the quality of the asset portfolio. These informa-
tional benefits to equity are not accounted for
in the M-M proposition.
Tax policy and subordinated debt as capital
Tax policy and deposit insurance, in contrast,
have tended to offset the bias in favor of equity.
Let us turn first to the effects of tax policy.
Because of the comparative treatment of debt
and equity in the corporate and personal income
tax laws, equity is made more costly than debt
on a tax-adjusted basis. (For example, interest
costs of debt are tax-deductible by corporations,
but dividends are not.) In banks (and other firms),
this contributes to the bias in favor of debt.
Bank regulators recognize this bias and have
permitted certain types of debt to be counted
as part of regulatory capital. In particular, under
present international regulatory agreements, 2
percentage points ofthe 8 percent capital re-
quirement can be in the form of subordinated
debt (SO). This does not fully eliminate the bias,
however, and expanded use of SO would permit
it to function more fully as a buffer for the
deposit insurance fund.
For SO to perform this function correctly,
however, certain conditions must be met. First,
the debt must be long-term so holders cannot10
o 3.5
1920 1930 1940 1950 1960 1970 1980 1990
•
•
2 3 4 5 6 789
Capital/Asset Ratio %
Source: Prudential-Bache Securities.
Chart 1
Spread Over Treasuries
Large Bank Subordinated Debt
(1990 Average)
100 T -- -f\1 __ §tart o.f ~ederal 15.5
90 ueposlt Insurance
(1933)
13.5
80
70
11.5
60 "v %Deposits Uninsured
50
\ ..
9.5 -\
~,
--\
40
\/\-
30
7.5
\
/1"-
20 Capital/Asset Ratio 5.5 -
400
200
500
300
Basis
Points
600
100
Chart 2
Deposit Insurance and Trends in Bank Leverage
Percent Percent
Second, the SO must not be insured. Although
this is an obvious point, a subtlety in regulatory
practice inadvertently causes subordinated debt
to be partly insured even if the debt is strictly at
risk: SO holders and the insurer have the same
seniority in liquidation, and losses are shared.
This reduces the "downside" risk faced by SO
holders, and thereby imparts partial deposit in-
surance coverage to this debt, regardless of its
explicit status. To make SO equivalent to equity
capital as an insurance fund buffer, SO holders
must have a claim on the bank that is junior to
the claim ofthe insurance fund.
"run" by redeeming the debt at the bank. If they
could redeem the debt on short notice, only eq-
uity capital would remain as an effective buffer
for the insurance fund.
An additional virtue of increasing the use of SO
as regulatory capital is that SO holders will have
a strong incentive to monitor the condition of the
banking firm. Indeed, with claims junior to the
insurance fund, they will wish to see the equity
ofthe bank maintained at safe levels. Even today,
with some implicit insurance of SO, the market-
place asserts some discipline by charging signifi-
cant premia over riskless rates for the SO issued
by undercapitalized institutions. (See Chart 1.)
Finally, for such debt to be marketed at feasible
yields, the SD holders must be senior to equity
holders, and have the power to force augmenta-
tion of bank equity or to demand liquidation Oi
sale of the bank. If they do not have this power,
then SO holders' wealth is at the mercy of the
insurer, whose only interest is in preserving
claims against itself, and bank SO likely would
not be attractive to investors.
FRBSF
Source: FDIC and FRB data.
Deposit insurance and bank capital
Oeposit insurance itself also is a major source
of bias in favor of bank debt. Specifically, if
deposit insurance premia underprice risk for
a particular institution, deposits will appear
cheaper than at-risk equity, and insured banks
will seek to minimize capital.
The historical data suggest clearly that this
has been the case. As indicated by Chart 2, the
passage ofthe deposit insurance law in 1933
immediately caused a significant decrease in
bank capital/asset ratios from an average of 12-15
percent before deposit insurance to about 5.5
percent in less than 10 years. Reductions in the
amount of uninsured deposits have continued
to depress capital ratios.
To correct this bias, either premia must be
raised, or the banks must raise capital suffi-
ciently to lower the probability of imposing a
burden on the fund. Simple finance theory can
show that either approach is equally costly. That
is, if a bank is enjoying a subsidy on its deposit
insurance, its costs will go up if higher capital
requirements are imposed. Its costs will go up
an equivalent amount if, alternatively, the proper
risk-based premia are implemented to eliminate
the subsidy.Practical considerations favor capital
As a practical matter, however, higher capital
requirements with low premia may be preferable
to a lower capital standard and higher premia
(and a larger fund). First, capital standards can
be implemented aggressively with less risk of
burdening banks than is the case with the high
premia approach. In particular, imagine that the
capital requirement is inadvertently set so high
that there is no longer any value to the deposit
insurance. If tax biases have been corrected
by SO policy, there is no burden to the bank's
wealth of this high capital requirement except
the (low) premium. That is, the bank's value is
indifferent, in the M-M sense, to the level of
equity, so that conservative errors in capital reg-
ulation are not costly. Inadvertently high premia,
on the other hand, depress bank value in direct
proportion to the error. That is, excessive premia
are a tax on bank earnings.
Second, with a flat, high premium, the well-
capitalized banks subsidize the less well-capi-
talized banks. The well-capitalized banks are
getting very Iittle benefit from the fund, but are
paying a high premium. The less well-capitalized
banks are gaining insurance with a value that
exceeds the premium they pay.
A higher capital standard, on the other hand,
makes the banks receiving the most subsidy
"pay" the most in declining bank value. If a
bank is receiving a subsidy from the insurance
fund, a higher capital standard, by "taking
away" the subsidy, will decrease the value
of the bank. A bank already enjoying no
subsidy will not be affected.
This "weeding out" effect of a higher capital
requirement is supported by a recent study by
Dahl and Spivey of the performance of severely
undercapitalized banks in the 1981-1988 period.
They concluded that new external equity issu-
ance is a critical determinant of recovery of the
bank; if forced to raise capital, the banks with
the least claim on the insurance fund were suc-
cessful and the ones with the greatest claim
were unsuccessful and failed to recover.
The competitiveness of well-capitalized banks
Theoretically, then, higher capital standards
appear to be irrelevant in determining the value
of a bank or its profitability and, hence, its
competitiveness. It is interesting to examine
the capital levels of our main foreign bank
competitors to see if this theory is supported.
Such comparisons are not easy to make using
the available book value accounting data, be-
cause most European and Japanese banks hold
corporate stocks and real estate assets whose
value has tended to be higher than the reported
book values.
An indication of the net worth of foreign banks
is implied, however, by the ratings conferred on
the debt of these institutions, since the capital
cushion is a primary determinant of this rating.
As of December 1990, of the 11 largest Japanese
banks only 2 have ratings below an S&P AA (or
Moody's equivalent) and one has a AAA rating.
Of the largest German banks, none are below
AA, and three have AAA ratings. All three of
the largest Swiss banks have AAA ratings. French
and British banks also enjoy high ratings. By
comparison, of the eight largest U.s. bank hold-
ing companies, only two are rated AA or above,
and three are rated BBB +.Many other u.s.
banks' debt is below investment grade.
Conclusion
Many other factors, of course, influence the
profitability and competitiveness of banks in
different countries. Indeed, we have argued in
previous Letters that it is the lack of commerce
powers of U.S. banks that is their greatest hand-
icap. Both theoretically and empirically, however,
there is little evidence that higher capital stand-
ards per se impair competitiveness. Indeed, if
anything certain U.s. banks unfairly compete
with other banks because of a subsidy received
via underpriced deposit insurance.
Retaining low capital standards and enlarging
the insurance fund creates biases in favor of
weak banks, and preserves the strong incentives,
on the margin, for banks to exploit the fund.
Modifications in the treatment of subordinated
debt and increased regulatory capital require-
ments offer better prospects for fairly reforming
deposit insurance. Put differently, our banking
system may be better off "self-insuring" through
higher capital than relying on an enlarged public
insurance fund.
RandallJ.Pozdena
Vice President
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (judith Goff) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
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Recapitalizing the banking system

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Recapitalizing the banking system

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