Credit creation is a very competitive market. Several major groups of financial intermediaries battle each other continually to increase their market share of 'credit created'. The net result is that the ratio of profits to assets, or ROA – Return on Assets, is very low. This ratio is often referred to as the operating leverage of the firm. Commercial banks as well as non-commercial bank depositories are considered as being very successful if they can earn profits equal to 1% of their assets or one dollar of profits per one hundred dollars of assets per year. That is a very low degree of operating leverage.
In order to earn a reasonable ratio of profits to owner's equity, or ROE - Return on Equity, commercial banks employ a relatively high degree of financial or debt leverage. This means that they finance most of their assets with the use of liabilities (debt). The typical large commercial banks will finance its assets with between 90% and 92% debt or liabilities and only 8% to 10% with capital, nearly all of which is owner's equity. Recall that owner's equity is equal to capital paid in by stockholders when the shares were first sold plus retained earnings (after tax profits not distributed to stockholders in the form of dividends).
In laymen’s terms, Owner's Equity is often simply called Net Worth. In our June Newsletter we analyzed the extent of the collapse in the American household’s net worth, since the financial meltdown occurred. In particular, we focused on the decline in the net worth of home values. The asset values of the homes fell, while the liability – the mortgages, did not follow suit. The result was a drop in the homeowner's net worth, or equity ownership stake in their homes.
On the flip side, the owners of the mortgage notes of homes that were in foreclosure had to write-down their owners’ equity. This included commercial banks and other non-commercial bank depositories. Further such write-downs are facing the lenders as strategic defaults and other such actions of households are becoming more common.
Commercial property values have also taken huge hits. Commercial banks with significant exposure to commercial bank loans have suffered significant impairment of their capital (remember most of the ‘capital’ of banks is owner’s equity). Many smaller community banks have suffered the most as can be seen in the recent increase in bank failures and closings. (See enclosed table)
On a further note, most Americans are also concerned with their equity position in their homes.
Looking at the change between 2006 and 2010
With the fall-off in the value of their assets (Real Estate) and the small rise in liabilities (Home Mortgage), their equity (Net Worth) position in their homes has declined significantly; moving from a 57% stake in 2006 to a 39% stake in 2010.
Moving back into the commercial arena…
The word capital in this context is a bit broader than the phrases owner's equity or net worth. It includes some longer term debt obligations such as bonds. But since banks do not offer very high rates on these obligations, they are relatively unimportant. A banks owner's equity or net worth is a useful surrogate for the term capital.
Capital or the very closely related concept, owner's equity, serves as a buffer when losses occur. If ALL of a firm’s assets were financed by debt or liabilities, a small loss would spell bankruptcy of the firm; its liabilities would quickly exceed its assets.
The Accounting Identity
Owner's Equity (net worth) = Assets – Liabilities
This is just as true for depositories such as commercial banks as it is for manufacturing or retailing firms. Then why employ any debt or liabilities in financing assets? Why not finance all a firm’s assets with only owner's equity?
That brings us to the concept of financial or debt leverage and the need to earn an acceptable return on the owner's investment (ratio of profits to owner's equity or ROE) in order to attract this type of capital to finance a firm’s assets and provide a buffer against bankruptcy. Financial theory explains that the return on equity or the ratio of profits to owner's equity is determined by the degree of a firms operating leverage or the ratio of profits to assets (ROA or return on assts) and the degree of financial or debt leverage of that firm (ratio of debt or liabilities to the firm’s assets). A simple example can shed light on these relationships.
Assume that a firm has $100 dollars in assets and that its profit is $5 for the year in question. That results in a return on assets or ROA of 5%.
How do the owners fare with this level of operating leverage and this ROA? It all depends. If no debt were utilized to finance the firm’s assets, owner’s equity would be $100 and the ROE or return on equity would be 5%. That is not very attractive for owners bearing the risks of a firm failing and wiping out their investment as GM stockholders recently experienced.
What if the firm financed one-half of its assets with debt or liabilities, a 50% ratio of debt to assets? Remember the balance sheet identity: the sum of the assets of a firm must be equal to the sum of its liabilities and owner's equity.
In this case the owner's equity would be $50 and the return on equity or ROE would rise to 10% ($5 of profit divided by $50 of owner's equity), a more reasonable reward to owners for investing in the firm and bearing the risk of the firm failing and wiping out their investment.
For a given level of profits, the less the assets and the more the debt used to finance the assets, the greater the return on owner's equity. Stated more precisely, the higher the degree of operating leverage (ratio of profits to assets or ROA) and the greater the degree of financial or debt leverage (ratio of liabilities to assets), the greater the return on equity (ROE).
In industries where competition is fierce, such as the credit creation industry, the ratio of profits to asset (ROA) tends to be relatively low. In commercial banking, a 1% return on assets earns the management kudos for performance. In order to earn a reasonable reward for owner's or return on equity (ROE), a relatively high degree of debt or financial leverage (ratio of liabilities to assets) must be used. As Shakespeare said, “ah, there is the rub!” The higher the degree of financial or debt leverage employed, the greater the vulnerability to bankruptcy, should losses occur. To mitigate this vulnerability, risk bearing by the highly financially leveraged commercial banks must be significantly limited in its credit creation activities.
In our example, if a commercial bank has a ratio of owner’s equity to assets of 10%, its owner’s equity would be $10. A return on assets of 1% would generate profits of $1 and a return on owner’s equity of 10%. Typical large commercial banks have capital ratios of closer to 8% and that would result in our example of a ROE of 12.5%.
CAUSE AND EFFECT – an examination of the effects of increasing capital ratios on commercial banks: Financial and operating leverage; interest rates; financial risk and rewards; and economic growth
As we have pointed out many times on this web site, commercial banks along with the other non-commercial bank depositories (formerly called thrift institutions: credit unions, savings banks and savings and loan associations), create credit by increasing the quantity of the checkable deposit form of M-1 money and “lending it out”. Put simply, the depositories monetize the debt of the borrowers (who swap their debt for the checkable deposit liabilities of the depositories which are a major portion of M-1 money).
The depositories’ checkable deposit liabilities are M-1 money while the borrowers’ debt or liabilities are not M-1 money. Remember that M-1 money is the medium of exchange version of the monetary aggregates.
Recall from other articles on this website, that all other financial intermediaries, contractual (e.g., pension funds and life insurance companies), borrowing (e.g., finance companies and federal credit agencies), and investing (e.g., mutual funds) cannot create credit in this manner. They must increase the velocity of M-1 money in order to create credit. They do so by offering owners of already existing M-1 money, substitute financial assets such as pension fund claims or a mutual fund shares. Depositories, such as commercial banks, can also create credit by increasing the velocity of existing M-1 money, but only depositories can create credit both ways. All financial intermediaries transform claims in the process of creating credit.
Recall that only depositories (commercial banks, savings banks, credit unions and savings and loan associations) can create credit by creating additional M-1 money and lending it out (in checkable deposit form: demand deposits, NOW accounts, share drafts at credit unions, and ATS accounts). Credit creation by non-depository financial intermediaries such as insurance companies, pension funds, finance companies and mutual funds, etc., is achieved by their increasing the velocity of existing M-1 money (by swapping substitute financial claims for already existing M-1 assets). These non-depository financial intermediaries cannot create checkable deposits and have to acquire the already existing M-1 money created by the depositories, usually in the process of creating credit. For example, a pension fund issues pension fund claims in exchange for checkable deposits from the contributors, either individuals or the firms that employ them. The pension fund can then lend the checkable deposits (M-1 money) by making loans or investments, i.e. creating credit.
CREDIT CREATION THROUGHFinancial Intermediation - In summary, the financial intermediary brings lenders (who want the least risk and highest return) together with borrowers (who want terms favorable to them --- low interest rates charged, longer period to pay back the loan, etc.). This process employs claims transformation, where the parties swap financial claims or securities to satisfy their financial objectives (e.g., a non-depository financial intermediary such as a pension fund acquires M-1 money in the form of contributions by or on behalf of the beneficiary. They ‘lend or invest’ the M-1 acquired from contributors to credit recipients who spend the funds and thus increase the velocity of otherwise idle M-1 money). Depository financial intermediaries such as commercial banks can do this as well but more importantly, depository financial intermediaries can create new M-1 money in checkable deposit form and lend it out.
Investment bankers such as Goldman Sachs and Merrill Lynch, in that role of ‘investment banking’, do not create credit but act as match-makers between buyers and sellers of financial securities as brokers, dealers, and underwriters. The exception to this would be the margin credit they extend to those that acquire the securities. In this function of match making, they do not transform claims and hence while facilitating the flow of credit, with very few exceptions, they do not create additional credit in the performance of the investment banking function.
Over the past few decades, changes in legislation and regulations have allowed holding companies to form that have both depositories and investment bankers under the umbrella of the same holding company. While the jury has been deliberating on the wisdom of these holding companies, an increasing number of critics are proclaiming that the growing dominance of holding companies is a policy mistake as these holding companies have developed over the past few decades. Despite the erection of so called firewalls of separation (Chinese Wall - http://en.wikipedia.org/wiki/Chinese_wall), the dominance of these holding companies has been one of the causes of the increasing financial instability of the U.S. financial system. The main obstacle in the past to such holding companies had been the Glass Steagall Act, which has know been rendered a relic of history. It is time to reconsider reinstatement of some form of this type of legislation.
The Glass-Steagall Act (enacted in 1933 --- 1999) http://www.federalreserve.gov/boarddocs/testimony/1998/19980617.htm forced the divestiture by commercial banks of most of their other non-depository activities such as insurance, investment banking (broker, dealer, and underwriter), etc. Since checkable deposits were rapidly becoming the more popular form of medium of exchange money (referred to as M-1 money nowadays), deposit insurance was enacted with the establishment of agencies such as the FDIC (About the FDIC - http://www.fdic.gov/anniversary/about.html).
Some thoughts from Federal Reserve Bank of Kansas City President Thomas Hoenig – June 2011 (speaking at Pew Financial Reform Project and New York University Stern School of Business)
Do SIFIS (systemically important financial institutions – code for too-big-to-fail) have a Future?
“Then, over the past 30 years, this safety net has expanded far beyond its original intent. More recently, Glass-Steagall was repealed, giving high-risk firms almost unlimited access to funds generated through their new access to the safety net. Finally, following a series of crises during the late 1980s and 1990s, the government confirmed that because of systemic impact, some institutions were just too big to fail—the largest institutions could put money in nearly any asset regardless of risk, and their creditors would not be held accountable for the risk taken. Predictably, the industry's risk profile increased dramatically. The SIFI was born.”
“For Hoenig though, the choice is clear when it comes to what to do with the financial institutions that caused the most punishing downturn since the Great Depression: break them up into pieces that regulators can understand and provide a backstop to entities engaged in the so-called real economy -- but allow those dabbling in more risk-laden activities to fail.”
MONETARISM: The modern day culmination of the Quantity Theory and guide for much of the legislation creating and controlling the conduct of monetary policy
In the U.S., monetary theory and policy and the legislation that guides it, have been dominated to one degree or another by some form of monetarism, the modern day version of the classical-neoclassical quantity theory. For the more casual reader of this article, you may find it helpful if you review some of the past articles on this website explaining these concepts in much greater detail.
Monetarism is the theory that is used to argue that a rapid and persistent growth in money will lead to inflation. Monetarism is a descendant of the old Quantity Theory of Money which was formalized in the 1700s but has even earlier precedents. But paper money (nearly all of which currently circulating in the U.S. and elsewhere, consists of Federal Reserve Notes) is part of currency, which in turn is part of what is termed M-1 money and the other broader monetary aggregates such as M-2 money. Currency is equal to the sum of this paper money plus the metallic coins issued by the Treasury.
We’ve already pointed out to you in the above cited articles that the Fed cannot force any significant increase in money and credit until profitability returns to the depository institutions. But even if profitability returns and the depositories increase the supply of money and credit significantly, it will not necessarily lead to inflation. To argue it will, means that monetarism is still a valid explanation of reality and a credible basis for determining monetary policy. It’s been very clear over the last 15-20 years that the velocities of the monetary aggregates (especially M1, M2 and M3) have not been related in a stable or consistent and statistically reliable manner to nominal GDP. For monetarism to be a valid explanation of inflation, requires if not a stable velocity or linkage to nominal GDP, it must have a statistically predictable linkage to GDP. This has not been the case in recent years.
Monetarism and its diminishing Relevance in the American Economy
Early in 2003, the President of the Federal Reserve Bank of Cleveland, Jerry Jordan, retired after over a decade in that position. Over a quarter of a century before that he became a well-known monetarist and wrote profusely on the topic as a senior research economist at the Federal Reserve Bank of St. Louis. Even better known as the high priest of Monetarism, is Milton Friedman (and Anna Schwartz Federal Reserve Bank of Minneapolis-The Region-Anna Schwartz on Milton Friedman (September 1998)), a long time Economics professor at the University of Chicago. While Monetarism comes in many variants, it argues that at least the excessive growth in money is a necessary condition for inflation but too many of this persuasion, it is a necessary and sufficient condition in causing inflation.
The roots of monetarism go back to the early quantity theory. As it evolved it took on more sophisticated forms, but the excessive growth of money was at the core of inflation. Essays on Inflation, written by Thomas M. Humphrey, was one of the best treatments of this evolution. The Federal Reserve Bank of Richmond published it in many editions in 1980s and is available through their website at http://www.richmondfed.org/research/economists/authors/humphrey2.cfm.
Monetarism is a line of reasoning emanating from the Quantity Theory. In a very early version (reference to David Hume http://www.econlib.org/library/enc/bios/hume.html), often called the crude quantity theory, prices on the average grew proportionally to the growth rate of money: Money times it Velocity equals Total Spending. Real output times it prices is the current dollar value of total output, today referred to as GDP. Since there are more than one definition of money and these definitions have changed over the years, a rough approximation of what money meant in this context would be what is called M-2 or thereabouts. The link between spending and money is referred to as the velocity of money. For example, if nominal or current dollar GDP for a year is 100 and the average quantity of money during that period is 50; the velocity of money is 2.
FED OFFICIALS CONSIDER RAISING THE CAPITAL RATIOS OF COMMERCIAL BANKS as the last few years have revealed excessive risk taking in their credit creation activities
Because of what regulatory officials have deemed excessive risk taking by commercial banks, the Federal Reserve System (FED) officials are once again considering increasing the capital requirements of commercial banks. What is the meaning of the term capital in this context and why raise the capital requirements of commercial banks?
JUNE 3, 2011 Fed Weighs Raising Capital Requirements For Banks
Often hidden in discussions such as this, is the risk reward relationship. In relatively efficient markets, the higher the yield or reward in percentage terms, the greater the level of risk that the investor must bear. Chasing yields or high rates of return is the same as chasing after risk. If one does not know this, one should not be in this profession!
If it is risk, it will materialize sooner or later. It is not a question of if it will materialize but when it will materialize.
As was pointed out earlier in this article, manufacturing and retailing firms know this and hence employ a relatively low level of financial or debt leverage, often less than 50% (ratio of liabilities to assets). But their return on assets (ROA or profits as a ratio to assets is often 5% or 10%, a far cry from 1% or less for the typical commercial bank. A return on assets of 10% is leveraged to a return on equity of 20% when liabilities are 50% of assets.
Think of the oil industry and firms such as Exxon Mobil where high profits and a moderate degree of financial leverage yields a return on equity in the mid-30% range even without subsidies, not bad, eh! Of course given the (re)cartelized nature of the oil industry, lack of competition affords the cartel control of supply and results in huge profits and high degree of operating leverage for these firms. Understand that the consumers ultimately pay the price of the cartels exploitive efforts. This is one of the reasons of the current prolonged economic malaise facing the U.S. The restrictions on the use of domestic energy sources and the resulting reliance of foreign sources of energy, is also a contributing factor in our ongoing economic crisis and high unemployment rates.
Connect the dots!
For a number of years, central bank officials under the auspices of the Bank for International Settlements (BIS) in Basel (http://www.bis.org/), Switzerland, have been experimenting with what are called risk based capital ratios. The riskier the assets, the greater should be the capital ratio or approximately the ratio of owner's equity to assets (ignoring the relatively small amount of long term borrowing by commercial banks). But what are the risks that require higher capital ratios.
If you have seriously studied finance or read the articles on this website, you have been exposed to a number of different financial risks: credit or default risk, interest rate risk consisting of price risk, reinvestment risk, sovereign risk, foreign exchange risk, etc.
The two components of interest rate risk are the price risk and the reinvestment risk.
The price risk is greater the longer the time to maturity and the lower the coupon rate.
The reinvestment risk is greater the higher the coupon rate.
This is what helps drive the inverse relationship. The combination of the coupon rate and the time to maturity determine the duration of the financial asset. Of course, the determination of these values is more precise for debt securities such as bonds where there is a contractual relationship and much less precise for equities such as common stock, where there is no contractual guarantee of the cash flow.
Interest rate risk should not be confused with credit or default risk. The only link between the two is a result of the risk premium reflecting the probability of default. The higher that probability, the higher is the coupon rate and hence, the smaller the interest rate risk. Other than that, the two types of risks, interest rate risk and credit or default are not related.
Long-term U.S. Government bonds have little credit or default risk but have a significant degree of interest rate risk.
You can eliminate the reinvestment risk part of interest rate risk by investing in zero coupon or pure discount debt securities such as bonds since there is nothing to reinvest, but as the coupon interest rates decreases, the price risk increases.
Given the huge deficits Congress legislated and the resulting quantum jump in U.S. national debt, further policies resulting in fiscal or budgetary deficits are now very costly to the integrity of the Dollar and the independence of our monetary authority, the Federal Reserve System. Similar policies in nations like Greece and Portugal have made everyone aware of the problem of sovereign risk, the growing threat of repudiation of a nation’s governmental debt.
The thinking is that since commercial banks want to raise their ROEs (Return on Equity) they are chasing more risk to obtain higher yields. They should then employ less financial or debt leverage which is what higher capital ratios achieve. The irony of this is that the reduced financial leverage offsets the higher yields that required higher levels of risk bearing, all else equal.
FINANCIAL MARKETS IN TRANSITION – 1995 Published by Federal Reserve Bank of Chicago (with Paul Ballew, Senior Research Economist, senior vice president of Consumer Insight & Analytics for the Nationwide Mutual Insurance Company)
LONGER TERM IMPLICATIONS FOR HIGHER CAPITAL RATIOS
Commercial bank failures fell sharply after the banking holiday closures under the Roosevelt administration. During the Great Depression, the number of commercial banks fell from over 25,000 to around 15,000 or about a 40% decline.
“An average of more than 600 banks per year failed between 1921 and 1929, which was ten times the rate of failure during the preceding decade.” …
“About 2,300 banks suspended operations in 1931 (Table 3-1). The number of failures thus exceeded the average number for the 1921-1929 period by almost threefold. Losses borne by depositors in 1931 exceeded losses for the entire 1921-1929 period.”
Failed commercial banks were fairly limited of late, until 2008.
The period of the Great Depression and the double dip of 1937 saw much legislation passed, often with insufficient reflection as to their consequences. A major piece of such legislation was the Glass-Steagall Act which separated the commercial banking function from other financial activities such as investment banking and insurance. A commercial bank could no longer be an investment bank with some exceptions such as dealing in government securities. Many other financial intermediation activities such as insurance were forbidden. The Federal Reserve administered a legal list of limited acceptable activities in which commercial banks could engage.
In the last thirty years or so, most of those constraints have fallen by the wayside as bank holding companies accumulated other subsidiaries once forbidden by the Glass-Steagall Act.
“Some Alternative Solutions to Ill-Conceived Bailouts…
2) Bring back a version of the Glass-Steagall Act: the goal – to separate investment banking from other financial services like the depositories, and insurance companies.”
As commercial banks create credit by acquiring higher yielding assets such as loans and investments, they are bearing more risk. Given their high degree of debt or financial leverage, i.e. low capital ratios, they become more vulnerable to bankruptcy. Remember that a large portion of their liabilities are checkable deposits that constitute over one-half of all M-1 money and facilitates around 90% of the legitimate economy’s transactions. The currency portion of M-1 money facilitates around 10% of the legitimate economy’s transactions. The currency facilitates almost all of the illegitimate economy or underground economy and well over half of the currency is held by people in the rest of the world.
As of December 2006, currency in circulation—that is, U.S. coins and paper currency in the hands of the public—totaled about $820 billion dollars. The amount of cash in circulation has risen rapidly in recent decades and much of the increase has been caused by demand from abroad. The Federal Reserve estimates that the majority of the cash in circulation today is outside the United States.
By some estimates, up to two-thirds of the currency in circulation is outside of the U.S.
The FED’s concern is partly due to the dominant role of checkable deposits in facilitating transactions in the legitimate or above ground economy in the U.S. Checkable deposits are the liabilities of the private sector’s depository institutions. Even though these deposits are insured by the FDIC up to $250,000, bankruptcy of depositories would reduce the value of the uninsured portion of these checkable deposits and reduce their ability to serve as the medium of exchange for the nation.
The ‘too big to fail’ doctrine was employed when much of the savings and loan industry went under and resulted in the collapse of the FSLIC, a wholly U.S. Government owned deposit insurance company.
Federal Savings and Loan Insurance Corporation (FSLIC)
“As the Fund balance dropped to be below 1.25 percent near the end of 2006, the FDIC began taking steps to maintain the Fund balance and liquidity.”
“Notwithstanding that 8 year requirement, however, the FDIC must take steps as necessary for the reserve ratio to reach 1.35 percent of estimated insured deposits by September 30, 2020”
The FED has been reluctant to use changes in legal reserve ratios to control the quantity of checkable deposit money and credit created by depositories such as commercial banks. Changes in such ratios change the revenue generating portion of the depository’s assets. With some exceptions, legal reserves of depositories are non-interest bearing assets. This problem would be partially solved if the FED would pay interest on legal reserves, especially when they take the form of reserve deposits at the FED. However this would reduce the profitability of the FED and thus the subsidy to the U.S. Treasury equal to 90% of the FED‘s profits.
The Financial Fiasco of Two-Thousand Eight (FFTTE) January 2, 2009
Assuming the additional legal reserves of depositories in the form of reserve deposits at the FED was to remain non-interest bearing; it would lower the operating leverage of the depositories such as commercial banks and lower their return on equity, all else equal.
Legislation could be passed to assess higher insurance premiums on deposits as the riskiness of the assets increased. The Federal Insurance agencies are notorious for assessing such premiums at too low a level. The Pension Benefit Guarantee Corporation (PBGC) http://www.pbgc.gov/news/other/res/financial-condition.html is another example. It can only withstand one more large hit or so before it becomes bankrupt. The “too big to fail doctrine” if properly funded, would re quire much higher insurance premiums from the larger depositories that have a strong enough political voice to prevent such a rational legislative and regulatory action.
Commercial banks have gradually become relatively less profitable compared to other financial intermediaries that create credit. Since the FED’s ability to conduct monetary policy is focused on the depositories, especially the commercial banks, the power of the FED to efficiently carry out monetary policies, like a slipping clutch, would further diminish. As the engineers say, lots of rpm’s but less and less torque. This is a classic ‘Catch 22’ issue.
To an increasing number of critics including Mr. Hoenig, President of the Federal Reserve Bank of Kansas City, reducing and altering the role of bank holding companies could be an important first step in solving the problem of increased instability of the U.S. financial system rather than the ‘Catch 22’ http://en.wikipedia.org/wiki/Catch-22_(logic) policies now being considered.