BANKS / THE FINANCIAL TIMES LEX ( HIGHLY RECOMMENDED READING )

Bank capital

Published: September 7 2009 09:30

No more funny money. Last Thursday, US Treasury Secretary Timothy Geithner said banks needed more capital – yet bank stocks rallied. This weekend, G20 finance ministers repeated the same – and that the capital had to be of higher quality, with lower investor payouts. And yet bank stocks have continued to rally.


Although the G20 has pledged to keep pumping out the stimulus for now, markets seem to be missing a trick. Bank share prices should be falling. Raising minimum capital adequacy ratios shrinks returns on equity. If banks have to hold a couple of extra cents for every dollar or euro that they generate, returns will suffer. Even fat years could be lean if buffers have to be built up during them.


Then there is the threat of equity issuance. In April, the International Monetary Fund estimated it would take $875bn of extra capital for US and European banks to boost tangible common equity as a proportion of total assets to 4 per cent. To get to 6 per cent, the mid-1990s norm, would cost $1,700bn. As the current combined market capitalisation of all US and European banks is around $2,000bn, that shows just how large rights issues could be - if such a “Basel III” scheme was ever implemented.

Equity investors would not suffer alone; bank debt investors would have to “burden-share” too. So far, bondholders have gained more from bank bailouts than shareholders. US bank stocks are some 40 per cent below where they traded last year. By contrast, credit default swap premia on bank debt are close to pre-Lehman levels, and spreads on US subordinated bank debt have returned to pre-Lehman heights. The knocks that the hybrid market has taken lately, after European governments told bailed-out banks to defer coupon payments, may be a sign of things to come. At the very least, the importance of the perpetual securities market will fall.

Of course, the other way for banks to manage capital ratios higher is to restrict asset growth, or even shrink balance sheets outright. Then the problem shifts to borrowers. That is bad for the economy. It is bad for stock markets too.