Capital and Language

The Fed Scrutinizes Bank Capital, in the Popular Imagination

Fed Governor Dan Tarullo gave important testimony on financial regulation September 9. It got widespread media coverage, for example Wall Street Journal and Bloomberg View.

The good news. The Fed wants more capital. Banks should absorb their own risks, rather than all of us to count on the Fed to stand over their shoulders and make sure they never lose money again.

Confusing language has long been a roadblock in this effort, along with red herrings passed along thoughtlessly.



"Costly"

The WSJ writes

The Federal Reserve plans to hit the biggest U.S. banks with a costly new requirement 

Mr. Tarullo's testimony does not contain any mention of the idea that higher capital requirements will be "costly."  My view, expressed nicely by Admanti and Hellwig's book, is that there is zero social cost to lots more bank equity.  Disagree if you will, but source it please, don't just pass it on as if the source said it or as if this is a fact like the sun coming up tomorrow.

"Hold"


Here are three uses of "hold" in the WSJ article [my emphasis]

 At issue is a requirement for the world's largest banks to hold an extra layer of financial padding in case of another crisis. 

Last week, the Fed and other regulators adopted another set of rules that require banks to hold very safe assets they can sell for cash in a pinch.

Mr. Tarullo said Fed officials are working on a separate rule that would require all financial firms—not just banks—to hold a minimum amount of securities or other collateral 

An unsophisticated reader could well be excused for thinking that "capital" is some special "asset" that the bank "holds" in reserve against losses. Banks "hold" loans, reserves at the Fed, gold coins in some Uncle-Scrooge vault, and this "capital," whatever that is.

No. Capital is where banks get money, not where they put it. It's a liability, not an asset. Capital has nothing to do with reserves, liquidity, safe assets or other "holdings."

No. Banks "issue" capital.  They "retain" capital if you must. But banks simply do not "hold" capital, and let's stop saying so.

Alas, this isn't just the journal, as Mr. Tarullo himself mis-spoke

By further increasing the amount of the most loss-absorbing form of capital that is required to be held by firms that potentially pose the greatest risk to financial stability, we intend to improve the resiliency of these firms,

"Charge"

There are 20 instances in the WSJ article of the word "charge" or "surcharge," starting with

the regulator intends to impose a capital surcharge that will require the biggest U.S. banks to maintain fatter cushions to protect against potential losses.

This is just as profoundly misleading. It sounds like the Fed is taxing the banks. Much as I would like a Pigouvian tax on short term debt, a capital requirement is nothing of the sort. Banks are not being "charged" a cent.

Alas, here too I can't fault the Journal too badly, as there are 14 instances of "charge" in Mr. Tarullo's testimony, starting with a section heading "GSIB risk-based capital surcharges." In turn, Mr. Tarullo is echoing the Basel committee's language.

We don't have to pass it on. We can say "additional capital requirement."

Bloomberg did a much better job (Byline just "editors" so I don't know who to praise here)

...Fed Governor Daniel Tarullo said that the central bank plans to subject systemically important banks to an added capital buffer significantly greater than what international rules require. The purpose of the so-called surcharge, which could be as much as several percent of risk-weighted assets, is to discourage complexity and fragility. It will be larger, for example, for banks that depend heavily on short-term funding of the kind that proved unreliable during the 2008 crisis. 

"Subject to" and the nice "so-called surcharge" avoid the red herrings nicely. And putting short-term funding right up front is spot on.

The Fed, for example, is requiring that banks have extra capital to absorb the costs of operational failures, 

"Have" is better than "hold."

But best of all, Bloomberg goes right at the common fallacies and explains it all nicely.

The Fed's efforts to make big banks fund themselves with more capital should not be perceived as punishment. Capital, also known as equity, is money that banks can use to make loans or fund whatever activities they choose. Because it doesn't have to be paid back like debt, it makes them more resilient in times of crisis -- a feature that should be seen as an advantage.

Nonetheless, the biggest U.S. banks operate with astonishingly little capital. As of June 30, the six largest U.S. banks had an average of about $5 in tangible equity for each $100 in assets (by international accounting standards) -- far less than smaller banks and enough to absorb a loss of only 5 percent of assets. Executives prefer to rely heavily on debt for two main reasons: It's relatively cheap thanks to various taxpayer subsidies, and it makes banks' performance -- measured as the return on equity -- look better in good times.

Aah, clarity at last. The article does not use "hold" or "held" once.

The PC left has a point: little words do matter.