If Banks Knew What Was Good For Them, They'd Be The First Pushing For Higher Capital Ratios


Warren Buffett describes certain types of business competition as a bit like standing on tippy-toes at a concert-in-the-park.  His particular story was in the textile industry of Berkshire Hathaway’s origin – management would come in and sell him on a (very expensive) new set of machinery which would improve productivity by say 30 per cent – and hence have a very high incremental return.

He would – after much arguing – agree to put in the machinery.  The same decision was made by every other textile mill in the country.  The marginal cost of producing textiles thus falls – and competition ensures that the price falls.  The machines thus raise productivity but do not raise profits – indeed shareholder returns [cash flows after compulsory (re)investment] fall.  Consumers benefit (which is the joy of competition) but from the textile mill owner’s point of view it would have been better had they just collectively sat on their collective backsides.  He likens this to standing at the concert in the park – individually rational perchance – but it is still better if everyone just uses their gluteal muscles.  

I feel the same about bank capital ratios.  In the UK banks were allowed to lever themselves to a silly extent (similar over-leverage occurs in their life insurance companies).  Overleverage as a policy was the defining character of Northern Rock.  

Individually it makes sense for banks to lever up.  However competition was intense – and collectively it was insane.  Northern Rock was levered 60 times or so – but to mortgages that were really thin margin.  Their spreads were about 40bps.  (I wrote my impression of Northern Rock down here…)

What I suspect is happening is all the banks are standing on tippy-toes.  It is individually rational – collectively insane because competition kills the benefit of all that extra leverage.  Margins in the UK – the most over-levered market on the planet – fell further than anywhere else.  

Of course competition was good for borrowers – at least for a while.  Lower spreads meant cheaper finance – but not dramatically cheaper.  Spreads of 150bps on mortgages levered 15 times is about as profitable as spreads of 40bps levered 60 times.  Competition might drive spreads down by 110bps – at the risk to the whole banking system.

Its bad for the shareholders in the end because the banks get their excessive ROE on a smaller amount of capital at much greater risk than in the safely – and excessively capitalised – regulated environment.

I mention this because of my perverse view that re-regulation – opposed by most bankers – might be surprisingly good for banks over the long run.  

The real winners and losers of deregulation

Competition – I argue – removed any real benefit of deregulation for bank shareholders.  (The benefits for bank management created by the sudden need to cope with this brave-new-world however were obvious.  They saw the opportunity and need to grow to maintain ROEs – and they lent with gay-abandon – taking all sorts of fees, commissions and bonuses along the way…)

The benefit for borrowers of competition however were dissipated in higher home prices and hence larger mortgages.  The real winners were people selling homes – not people buying them.  Even quite modest houses became valuable – and the elderly (the classic group moving to less expensive homes) did quite well.  I haven’t heard the expression “old and poor” quite as much as I used to.  More generally you can see the relatively affluence of the elderly in the sell-the-home and go cruising set.  Carnival Cruises was – for a very long time – a better stock than you might ever have imagined.

The other supposed beneficiary was suffering an illusion.  Plenty of people – especially in their children’s teenage years – had an-in-the-end-illusory wealth effect – where they thought their home was worth much more than it was – and felt confidence in spending some of that money – or in saving less for their retirement – because after all they could downsize and they might inherit part of Grandma’s (housing) fortune.  

Net-net the losers out of excessive bank leverage were (a) the shareholders because they got lower spreads and took more risk, (b) taxpayers because they partly bore the risk and (c) younger home buyers because they got royally-rogered by the elderly people they bought from.

I am waiting for some bank management – particularly a stronger incumbent – to see it that way and advocate sweeping bank re-regulation which will (a) reduce taxpayer risk (b) increase spreads and (c) reduce leverage.  This will allow the strong incumbent to earn a good ROE at little risk on a lot more capital and will make the bank’s shares a surprisingly good investment.  

I doubt I am going to see it.  These are the sort of @&$?! who stand up on their tippy-toes in front of you at Opera in the Park.



This guest post previously appeared at Bronte Capital >

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