Friday, May 24, 2013

Ask a banker, and listen to what they say!

Nice post on Planet Money which actually gets many of the facts right! Unfortunately, they do not see how these facts actually pull together, and so do not quite capture the core insight into bank operations. But overall, it's a nice piece.
So, on some simplistic assumptions, capital is just the result of some arithmetic:
Capital is how much money would be left in the bank if you sold all the bank's stuff and paid off all its debts.
If you actually did that - and you wouldn't, it wouldn't really work out this way, but pretend - if you actually did that then that leftover money would go to JPMorgan's shareholders. They're what's called the "residual claimants," which just means that they get what's left after everyone else has been paid off.**** So the capital is sometimes called "shareholders' capital," because it belongs to them.
Yes, not bad! They've shown a balance sheet, and highlighted how capital is, in some sense, the stub value between assets and liabilities.
Those arithmetic definitions of capital should make clear an important fact: if a bank loses money, its capital is reduced before any of its debts are. The capital is the "first-loss position"; sometimes people say it "absorbs" losses. If JPMorgan just misplaces $100 billion of cash, then its assets will go from $2.4 trillion to $2.3 trillion, but its debts won't change by a penny: it'll still owe various bondholders, depositors, etc. a total of about $2.3 trillion. This means that its capital will now be $107 billion, say, instead of $207 billion: the entire $100 billion loss will go directly to the people who own stock in JPMorgan — the people with a claim on JPMorgan's capital. If JPMorgan misplaces $300 billion of cash, then its capital will be zero, and the stock in JPMorgan will be worth zero. On top of that, some of the people who loaned money to JPMorgan won't be paid back.
Yes, this is core fact. Capital is money in first loss position. If you want banks to make more responsible credit decisions, you need to put the folks who own the bank (shareholders) in more of a first loss position for when those decisions turn out to be wrong. That, by itself, is a strong argument for higher capital levels.
But there's another issue, which is that banks - and their shareholders - tend to like leverage, which is the superpower that borrowed money creates. Borrowing money - especially when you can borrow it really cheaply, like you can today - allows you to magnify your profits and losses. Magnifying your profits is good for shareholders (they get the profits!). Magnifying your losses isn't great, but since the shareholders don't necessarily suffer all of the losses (their shares can't go below zero), they might still prefer to take the risk. "Capital," remember, just refers to money that the bank hasn't borrowed: the more capital a bank has, by definition, the less leverage it has.
Great point. When you have an asymmetric payout structure (heads I win, tails I get bailed out) then increasing risk is the rational strategy. Lower capital, combined with the structural reasons we have had and will continue to have tax payer bailouts, increase this risk and so help banks make more money.

The article then gets lost in the maze of liquidity, not understand regulatory capital requirements, the forbearance thereof, and not looking at the very strange role the overnight interbank market and Fed discount window plays in all of this. Oh well. However, at the end it just becomes wrong.
But sometimes that's a good secret to keep. Ultimately banks get their money from people. People for putting money into banks in "safe" forms (deposits, etc.), rather than "risky" forms (shares of stock). If regulation shifts the mix into more "risky" forms of bank financing - if it makes people face up to the risks of their banks - then they will have a harder time satisfying that preference for safe assets. Then what happens?
Deposits are not substitutes for equity investments. Banks do not get their money to make loans from deposits. On the contrary, bank make loans out of thin air which then create deposits.

5 Comments:

Blogger Ramanan said...

About your last para, I think the article quote is saying something other than what you think.

It is saying that some people prefer to have their financial wealth in the form of non-risky assets such as deposits, rather than buy equities.

In general people prefer a mix between non-risky and risky financial assets and do not want to worry about the former at least.

If banks get risky, people have a chance of losing their deposits and this is not something they want to worry about.

The last quote alone doesn't show the ignorance of "loans make deposits".

3:20 PM  
Blogger winterspeak said...

Ramanan:

Perhaps you are right. It is difficult for me to interpret exactly what they mean.

The article says "[banks exist to] take money entrusted to them for safekeeping and lend it out to fund the risky activities that help our economy grow, without scaring people about the risk".

The sounds more like lending out deposits to me, not extending loans against an investment.

3:43 PM  
Blogger Ramanan said...

Winterspeak,

Yes that quote sounds like what you say about the author/article especially because the article is written as a tutorial and the author should have been mentioned that loans create deposits.

4:57 PM  
Blogger widmerpool said...

Tangential question:

Can banks pay themselves with the interest they receive on excess reserves?

On one hand, I hear people (eg Mark Dow) saying reserves are a closed system.

Then people say banks don't need to lend b/c they get paid just to hold reserves.

Who's right?

10:10 AM  
Blogger winterspeak said...

Hi widmerpool

Banks actually pay for things the same way they make loans -- they just expand both sides of their balance sheet.

Banks aren't making loans because they get paid just to hold reserves. Banks aren't making loans because there isn't much demand for profitable loans because the economy is weak, and still somewhat over leveraged.

6:54 AM  

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