Americans do not have a lot of love for the banks these days. Most Americans do not understand the complexities of the credit markets (neither do many people working in the credit markets). Most people feel that the bailout is rewarding bad behavior. Managers that took ignorant risks and led their companies into the ground are receiving huge sums of public money. Whether or not the big banks DESERVE to receive capital injections from our tax payer dollars is certainly debatable, but this article will discuss the question I’ve heard quite a bit lately, which is, “why do they need it?”
The short answer is they need it because they are suffering historic losses, resulting in an erosion of their capital base, leaving them undercapitalized. Regulators require banks to meet certain minimum capital requirements. The big National Banks (i.e BofA, Wells Fargo, Citibank, JPMorgan Chase, etc…) are governed by the Office of the Comptroller of the Currency, or OCC for short, whose primary mission is “to ensure the safety and soundness of the national banking system.” If the letters N.A. or NT&SA follow your bank’s name on your checks, your bank falls into this category. These National Banks hold approximately 70% of the banking assets in the U.S., so it is easy to see their importance to our financial system.
The OCC requires banks to stash some of their cash (or create reserves) as an important cushion against unexpected losses from today’s loans that may go bad in future years. It is impossible to know today exactly which specific loans will go bad, otherwise the bank wouldn’t make them, and so they just make an estimate (say 2% - 5%) on total loan volume for the year. When loans actually go bad, they are written off against this stash. When the bank’s estimate is wrong and more loans go bad than their original estimate, the losses exceed the stash, meaning the bank becomes undercapitalized and requires more capital to remain in business. In theory, this rule should create a strong incentive to manage a bank in a prudent manner because the bank owners’ equity is at risk in the event of failure. The OCC requires the stash to be risk weighted, meaning that the bank must set aside more capital for risky assets (loan to flaky friend) than for safe ones (loan to best friend), which leads us to why they are asking for more capital.
As individuals default on home loans and as consumers stop shopping, as they have, repayment on those mortgages and business loans slows, requiring the banks to down grade some of the remaining loans in their portfolios. In some case, regulators call for multi-notch downgrades (i.e. from “top notch” to “junk” status), requiring the bank to make significant additions to the stash. Junk rated debt carries an especially punitive risk weighting, as banks must set aside five times more capital than they have to for top notch debt. A larger stash leaves a bank with less capital to lend, which leads to less credit available to consumers to buy homes, cars, TVs and clothes. Without government intervention, the vicious cycle would continue to recur until the whole system ultimately grinds to a halt.
Under the Treasury Department’s new bank bailout program, proposed this week, banks will be required to undergo a “stress test” to determine if they: 1) can keep lending and 2) can stay in business if the downturn worsens. Some think this requirement was strategically placed by the Obama Administration as a non-ideological way to prove to the public that individual banks need to be nationalized, or taken over by the government.
While most Americans are frustrated with how the funds to date have been used, the problems resulting from non-action could cause the entire system to crash. Approximately 40% of lending in the U.S. flows through the secondary credit markets, which makes lending possible, and right now that market is frozen. The banks need more capital to make new loans. Let’s only hope they actually make more loans.
