The Basel Committee on Banking Supervision, a global group made up of central banks, just came out with its new bank capital standards, the Third Basel Accord (Basel III), to address some of the problems and weaknesses in global financial regulation.
The debate around “too big to fail” of the US banking system is often infused with political rhetoric and media hype. Let’s go through some Q&A on the subject and discuss the facts.
Q: Did large banks take disproportionate amounts of real-estate related risk vs. smaller banks prior to the crisis?
A: No. That’s a myth. Smaller banks were much more exposed to real estate (see discussion).
Q: Which “too big to fail” banks were directly bailed out by the US federal authorities during the 2008 crisis?
A: While hundreds of banks were forced to take TARP funds, only Citigroup (among US banks) received an explicit bailout to keep it afloat. Note that Bear Stearns (and Lehman), AIG, GM/GMAC, Chrysler, Fannie and Freddie were not banks. Neither was GE Capital and other corporations who relied on commercial paper funding and needed the Fed’s help to keep them afloat. Wachovia may have become the second such large bank if it wasn’t purchased by Wells.
Q: Why did Citi fail in 2008?
A: Citi ran into trouble because of a massive off-balance-sheet portfolio the firm funded with commercial paper. In late 2007, when the commercial paper market dried up, Citi was forced to take these assets onto its balance sheet. The bank was not sufficiently capitalized to absorb the losses resulting from these assets being written down.
Q: What were the assets Citi was “warehousing” off-balance-sheet?
A: A great deal of that portfolio was the “AAA” and other senior tranches of CDOs that Citi often helped originate (including mortgage related assets). Rating agencies were instrumental in helping banks like Citi structure these assets and keep them off balance sheet in CP conduits.
Q: Why did Citi (as well as many other banks) hold so much off-balance sheet?
A: Because they received a significantly more favorable capital treatment by doing so (the so-called “regulatory capital arbitrage” – see discussion from 2009).
Q: Did Citi break any state or federal laws by doing what it did?
A: No. All of this was perfectly legal and federal authorities were aware of these structures.
Q: Did derivatives positions play a major role in Citi’s failure? Were other large US banks at risk of failure due to derivatives positions?
A: No. That’s a myth. The bulk of structured credit positions (tranches) that brought down Citi were not derivatives (just to be clear, CDOs are not derivatives).
Q: What has been done since 2008 to make sure the Citi situation doesn’t happen again?
A:
- The US regulators now have the ability to take over and manage an orderly unwind of any large US chartered bank. Banks are required to create a “living will” to guide the regulators in the unwind process. The goal is to force losses on creditors in an orderly fashion without significant disruptions to the financial system and without utilizing taxpayer money.
- Large banking institutions are now required to have more punitive capital ratios than smaller banks.
- Capital loopholes related to off-balance-sheet positions have been closed.
- Stress testing conducted by the Fed takes into account on- and off-balance sheet assets, forcing banks to maintain sufficient capital to be able to take a hit. US banks more than doubled the weighted average tier one common equity ratio since the crisis (see attached).
Q: Do large US banks have a funding advantage relative to small banks?
A: Not any longer. According to notes from the meeting of the Federal Advisory Council
and the Board of Governors (attached – h/t Colin Wiles @forteology), “Studies point to a significant decrease in any funding advantage that large U.S. financial institutions may have had in the past relative to smaller financial institutions and also relative to nonfinancial institutions at comparable ratings levels. Increased capital and liquidity, in addition to meeting the demands of many regulatory bodies, has largely, if not entirely, eroded any cost-of-funding advantage that large banks may have had.”
Q: What is the downside of breaking up banks like JPMorgan?
A: Large US corporations need large banks to provide credit and capital markets access/services (Boeing is not going to use Queens County Savings Bank). Without large US banks, US companies will turn to foreign banks and will be at the mercy of those institutions’ capital availability and regulatory frameworks. Foreign banks will also begin dominating US capital markets primary activities (bond issuance, IPOs, debt syndications, etc.) And in an event of a credit crisis foreign banks (who are to some extent controlled by foreign governments) will give priority to their domestic corporations, putting US firms at risk.
Q: How large are US largest banks relative to the US total economic output? How does it compare to other countries?
A: See chart below:
So before jumping on the “too big to fail” bandwagon, get the facts.
Meeting of the Federal Advisory Council
From our sponsor:
This is a syndicated repost published with the permission of The Baseline Scenario. To view original, click here. Opinions herein are not those of the Wall…
After the Ferbruary post on the flaws of Basel III regulation (see discussion) we got a number of emails pointing to the importance of uniform global banking rules. “By criticizing Basel III you support these banksters” was one of the comments. Of…
BloombergBanks May Need $566 Billion to Plug Capital Gap, Fitch SaysBloombergThe world's biggest banks may have to raise about $566 billion of common equity to meet rules on capital to be implemented by 2019, curtailing shareholder returns, accordi…
BloombergBanks May Need $566 Billion to Plug Capital Gap, Fitch SaysBloombergThe world's biggest banks may have to raise about $566 billion of common equity to meet rules on capital to be implemented by 2019, curtailing shareholder returns, accordi…
The Bank of Canada has released the Financial Stability Review for December 2011 with articles:
Risk Assessment
Macrofinancial Conditions
Key Risks
Global Sovereign Debt
Economic Downturn in Advanced Economies
Global Imbalances
Low Interest Rate Environment in Major Advanced Economies
Canadian Household Finances
Safeguarding Financial Stability
Strengthening Bank Management of Liquidity Risk:
The Basel III Liquidity Standards
A Fundamental Review of Capital Charges Associated
with Trading Activities
Click for Big
Market-making […]
All last week across the media landscape, in pod, blog, flat-screen, and crunkly old newsprint columns, fatuous professional observers complained that the Occupy Wall Street marchers “have no clear agenda” or “can’t articulate their positions.” What…
The world is undercollateralized. This is the single most important feature of the 2011 economy. Sixty years ago, if assets were worth less than loans, it was possible to work our way into the black. In 1950, 59% of US corporate profits were from m…