Monday, September 6, 2010

Bank capital ratios and standing on tippy-toes

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 percent - 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 capitalized - 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.








PS. Thanks for the many comments on the gold post.  My inbox is also filled so if I do not answer all of your emails it is because they are so numerous.  (I read them all though!)


Hans Suter said...

it seems that there is a good chance that this operation can be repeated, there seems to be room for house prices to go down further:

Anonymous said...


What about the Australian house prices? they seem to just stay high


Anonymous said...


what's happening at the Australian banks? stock prices (as multiple of BV) seem high but... RE prices are very high (median Australian home is something like 2x median US home) and -- i have seen reports that Sydney and Melborne RE prices are up 20% last 12 months... do trees grow all the way to the sky on the southern hemisphere or are we about to see Banking Crisis Australian Edition soon?

John Hempton said...

You could lose a lot of money calling a top in Australian real estate ...

There is NO SIGN of stress a the moment - but all you say is true.


But What do I Know? said...

This is great, John. Thanks for laying out the case that high house prices (and asset prices in general) are a win/lose proposition--good for some and bad for others. Now if we could only get Ben Bernancke to understand that before he launches what is now being called "real QE."

Down in front!

Unknown said...

To some extent this is almost a case of the wrong de-regulation. By this I mean that they de-regulated the performance & standards of lending (e.g. leverage ratios).

Instead what would have made more sense was to reduce the barriers to entering the market in form of the licenses. So new entrants can enter the market but still have to meet the same performance standards.

Everything I've seen indicates it is wrong to re-regulate behaviour & the punishment of bad behaviour but it is right to remove regulation that acts as a barrier to entry to new entrants. More often than not de-regulation has been about behaviour and not about barriers to entry.

MrM said...

Any discussion on the impact and beneficiaries of de-regulation (and re-regulation), which does not address the issue of incentive compensations, is incomplete.

Yes, the shareholders did not benefit all that much, especially taking into account the stock price performance over the past 3 years. Yet, bank executives, even of those banks that failed, benefited enormously.

Resistance to regulatory oversight of executive compensation is the main reason behind the bank's resistance to re-regulation.

Guillaume said...

John, you are coming to a conclusion that is surprisingly similar to that of Marxist historian Robert Brenner, who suggests that overcompetition and reduced profits are preventing capital from realizing its full potential. He argues that this is the driving force behind the slowdown in growth since the 70s.

Anonymous said...

Interesting facts on UK mortgage industry:

1. They are always recourse => less probability of full loss even when negative equity loan
2. Banks do not offer fixed mortgages spread over multi year horizon. Fixed deals give a fixed rate for about 2 years and then revert to a floating rate => very small interest risk for the bank

Given the above two is it a surprise that the banks want to load up on as many loans as possible ? Key problem is the inherent assumption in the mind of the mortgage lender that he will get his money back someway or the other...

babar ganesh said...

i suppose you could make the argument then that if banks had had more capital than they did, they could have had more sketchy loans than they did before provoking a crisis.

Anonymous said...


"You could lose a lot of money calling a top in Australian real estate ...

do you figure there are objective rules for overvaluation? such as x times disposable income or x times gdp per capita? on such measures... are we there yet?

or is australia like taiwan where RE prices float sky high on mainland chinese capital expatriation?

polit2k said...

Like you I'm not holding my breath.

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Will said...

From a UK perspective- you only need to stand on your tip toes if the concert is full of people. If there are only a handful of people in the room noone needs to stand. Right now the number of people writing mortgages in the UK market has gone from 150 to 5. All the wholesale funded competition has gone. If you have a deposit base you can write mortgages at hugely profitable rates. The government policy is to encourage more competition (although the regulator has some tough requirements for new entrants). The rational thing for bank management to do is to sit tight and say nothing, while enjoying the ride.

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