GREENSPAN, BANKS NEED MORE CAPITAL

-BANKS NEED MORE CAPITAL

Dec 18th 2008

In a guest article, Alan Greenspan says banks will need much thicker
capital cushions than they had before the bust

GLOBAL financial intermediation is broken. That intricate and
interdependent system directing the world's saving into productive
capital investment was severely weakened in August 2007. The disclosure
that highly leveraged financial institutions were holding toxic
securitised American subprime mortgages shocked market participants.
For a year, banks struggled to respond to investor demands for larger
capital cushions. But the effort fell short and in the wake of the
Lehman Brothers default on September 15th 2008, the system cracked.
Banks, fearful of their own solvency, all but stopped lending. Issuance
of corporate bonds, commercial paper and a wide variety of other
financial products largely ceased. Credit-financed economic activity
was brought to a virtual standstill. The world faced a major financial
crisis.

For decades, holders of the liabilities of banks in the United States
had felt secure with the protection of a modest equity-capital cushion,
allowing banks to lend freely. As recently as the summer of 2006, with
average book capital at 10%, a federal agency noted that "more than 99%
of all insured institutions met or exceeded the requirements of the
highest regulatory capital standards."

Today, fearful investors clearly require a far larger capital cushion
to lend, unsecured, to any financial intermediary. When bank book
capital finally adjusts to current market imperatives, it may well
reach its highest levels in 75 years, at least temporarily (see chart).
It is not a stretch to infer that these heightened levels will be the
basis of a new regulatory system.

The three-month LIBOR/Overnight Index Swap (OIS) spread, a measure of
market perceptions of potential bank insolvency and thus of extra
capital needs, rose from a long-standing ten basis points in the summer
of 2007 to 90 points by that autumn. Though elevated, the LIBOR/OIS
spread appeared range-bound for about a year up to mid-September 2008.
The Lehman default, however, drove LIBOR/OIS up markedly. It reached a
riveting 364 basis points on October 10th.

The passage by Congress of the $700 billion Troubled Assets Relief
Programme (TARP) on October 3rd eased, but did not erase, the
post-Lehman surge in LIBOR/OIS. The spread apparently stalled in
mid-November and remains worryingly high.

How much extra capital, both private and sovereign, will investors
require of banks and other intermediaries to conclude that they are not
at significant risk in holding financial institutions' deposits or
debt, a precondition to solving the crisis?

The insertion, last month, of $250 billion of equity into American
banks through TARP (a two-percentage-point addition to capital-asset
ratios) halved the post-Lehman surge of the LIBOR/OIS spread. Assuming
modest further write-offs, simple linear extrapolation would suggest
that another $250 billion would bring the spread back to near its
pre-crisis norm. This arithmetic would imply that investors now require
14% capital rather than the 10% of mid-2006. Such linear calculations,
of course, can only be very rough approximations. But recent data do
suggest that, while helpful, the Treasury's $250 billion goes only
partway towards the levels required to support renewed lending.

Government credit has in effect acted as counterparty to a large
segment of the financial intermediary system. But for reasons that go
beyond the scope of this note, I strongly believe that the use of
government credit must be temporary. What, then, will be the source of
the new private capital that allows sovereign lending to be withdrawn?
Eventually, the most credible source is a partial restoration of the
$30 trillion of global stockmarket value wiped out this year, which
would enable banks to raise the needed equity. Markets are being
suppressed by a degree of fear not experienced since the early 20th
century (1907 and 1932 come to mind). Human nature being what it is, we
can count on a market reversal, hopefully, within six months to a year.

Though capital gains cannot finance physical investment, they can
replenish balance-sheets. This can best be seen in the context of the
consolidated balance-sheet of the world economy. All debt and
derivative claims are offset in global accounting consolidation, but
capital is not. This leaves the market value of the world's real
physical and intellectual assets reflected as capital. Obviously,
higher global stock prices will enlarge the pool of equity that can
facilitate the recapitalisation of financial institutions. Lower stock
prices can impede the process. A higher level of equity, of course,
makes it easier to issue debt.

Another critical price for the return of global financial stability is
that of American homes. Those prices are likely to stabilise next year
and with them the levels of home equity--the ultimate collateral for
global holdings of American mortgage-backed securities, some toxic.
Home-price stabilisation will help clarify the market value of
financial institutions' assets and therefore more closely equate the
size of their book capital with the realities of market pricing. That
should help stabilise their stock prices. The eventual partial recovery
of global equities, as fear inevitably dissipates, should do the rest.
Temporary public capital injections into banks would facilitate this
process and arguably provide far more benefit per dollar than
conventional fiscal stimulus.

Even before the market linkages among banks, other financial
institutions and non-financial businesses are fully re-established, we
will need to start unwinding the massive sovereign credit and
guarantees put in place during the crisis, now estimated at $7
trillion. The economics of such a course are fairly clear. The politics
of draining off that much credit support in a timely way is quite
another matter.

For a discussion of this article, see www.economist.com/freeexchange[1]

See this article with graphics and related items at http://www.economist.com/finance/displayStory.cfm?story_id=12813430&source=hptextfeature

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