TheCommonEquityProbleminBankRegulation

YeshaYadav,Vanderbilt LawSchoolIGIDREMFConference2017

Motivation• Bankingregulationhasbeensubjecttoenormoustransformationsincethe2008-FinancialCrisis.

• Nowwellknown,bankssufferedcatastrophiclossesin2008-2010andregulatorsaroundtheworldrespondedwithaslewofmeasures.

• ThroughtheBaselCommitteeonBankingRegulationandBaselIII,regulatorshavesoughtto(i)increasecapitalbufferswithmuchmoreequity;(ii)ensuregreaterliquidreserves;and(iii)eliminatetoo-big-to-failthroughorderlyliquidationprocedures.

• TheDodd-FrankActimplementsthisconsensusbyrampinguprequiredcapitalbuffersandliquidityreserves,mandatingstresstestsandintroducingTitleII’sOLA.

Source, Economist, World’s BiggestBankLosses, June 252009

U.S.BanksandWrite-Downs• Anumberofbankssawmassivewrite-downsduringtheCrisisandsharpfallsinthevalueoftheirequity:

Source:Bloomberg

Bank Credit Losses &Write-Downs(Billions) (Jun2007-March 2010)

EquityReturn(June2007-Dec2008)

Citigroup 130.4 -82.46%

Wachovia 101.9 -88.34%

BankofAmerica 97.6 -67.79%

JP Morgan 69.0 -31.51%

Merrill Lynch 55.9 -85.16%

Wells Fargo 47.4 -10.77%

U.S.BankCapitalBuffersPre-Crisis

• MostU.S.bankswereregardedaswell-capitalizedpriortotheCrisisandhadcapitalbuffersmuchinexcessofBasel’s8%ratioofcapitaltorisk-weightedassets.

• TheTop-20U.S.banksaveragedanaveragecapitalratioof11.6%.

• Post-Crisiscriticismsarguethatthequalityofbankcapitalwassub-optimal:didnotincludeenoughTier1Equity:purecapitaltoabsorbbanklossesandassistresolution.

• U.S.bankshadtakenonexposuresthatweretoocomplexandlargetobesustainedbytheirlevelsofcapital.

TurntoEquityPost-Crisis• Thepost-Crisisconsensushasseenamarkedturntocommonequityastheprotectivebulwarkagainstcripplinglossesandtoo-big-to-fail.

• Equityoffersbluntandreadyprotectionagainstgeneralizedrisksthatcanaffectabank.ScholarslikeAdmati andHelwig haveproposedequitybuffersofaround20%ofRWA.

Capital RequirementsBaselIII/Federal Reserve % EquityBuffer

Common Equity Tier1 4.5% (4.5%+1.5% Tier1)

CET Countercyclical Capital Buffer 0-2.5%

CETCapital Conversation Buffer Greaterthan 2.5%

CETG-SIB Surcharge (U.S.version) 1-4.5%

WhoSuppliestheEquity?

• U.S.capitalmarketshaveundergonedeepinstitutionalizationsincethe1960s-70s.

• Ratherthaninvestingindividually,U.S.homesandbusinessesinsteadinvestthroughfundsandassetmanagerslikeBlackRock,Vanguard,FidelityorStateStreet.

• Thesefirmshaveevolvedtobecomethelargestpoolsofcapital.Fundsrunbythesefirmsinvestmoneyforhomes,businessesandfinancialfirmsacrossU.S.capitalmarkets.

• Theyarealsoextremelypowerfulshareholdersincorporategovernance.

KeyAssetManagers

• BlackRockisthebiggestshareholderintheworld.Itmanagesaround$4.9trilliondollarsinassets– morethanallhedgefundsandPEfundsputtogether.

• Vanguardmanages$3.5trillioninassetsgloballyandFidelityaround$2.06trillion.

• BlackRockreportedlyhasinvestmentsinalmostalllistedcompaniesintheU.S.,andindeedhasanenormousfootprintaroundtheglobe.

• BlackRockalsorunsAladdin,anoperatingsystemthathelpsdirectaround$11trillionworthofinvestmentsbasedonitsriskanalytics.

CommonOwnership

• Antitrusteconomistshavepointedtoariseinpervasive“commonownership”inU.S.capitalmarkets.

• Commonownershipor“horizontalshareholding”(Elhauge)describesthephenomenonofasmallnumberofshareholdersoccupyingblockholderpositions indifferentcompaniesinthesameindustry.

• Fortheseeconomists,theriseofcommonownership,becomingentrenchedsincethegradualinstitutionalizationofthemarketpointstohighercosts,lesscompetitiveservice.

• Bankingissingledoutasindustrywherecommonownershipisdominant.

SurveyResults

• IlookedatthelargestpublicallytradedU.S.bankstoexaminetheirmajorprovidersofequitycapital.IexcludedbankswhoseheadofficeislocatedoutsideU.S.

• Outofthe25banksexamined,22includedbothVanguardfundsandBlackRockfundsasholdersofmorethan5%oftheircommonequity.

• VanguardandBlackRockwerealsoholdersofmorethan5%equityintheholdingcompaniesoffinancialinfrastructureproviders:ICE,NASDAQ,CMEandCBOEHoldings.

• StateStreetheldover5%equityineightbankholdingcompanies;Fidelityin7bankholdingcompanies;BerkshireHathawayandT.RowePriceinfourcompanies.

Rationale• Thismakessense.U.S.bankshavebeenhungryforequitycapitalsince2007-8.Theyhaveraisedover$400billiondollarsworthinequitycapital.

• Theselargeequitymanagersrepresentthedeepestandmostabundantpoolsofcapitalintheeconomy.

• InvestinginBHOsmightbesaidtorepresentastrategytogarnerexposuretoaswathofthebroadereconomythroughbanklendingdecisions.

• Inthelastquarters,bankrevenuehasperformedwell,withlargeprofitsreported.Though,byandlarge,bankinghasbeenvolatileandunprofitablesince2010.

Risks– ExAnte• Thedominanceofcommonownersasbigblockholdersinthevastmajorityoflarge,systemicallyimportantbanksposesrisks:

Ø Ontheonehand,theymayhaveinformationadvantagesbydintofcommonownershipacrossbanking.However,bankinformationisnotoriouslyopaque.Short-termcreditorsaregenerallyinformation-insensitive.

ØErrorsininterpretingthisinformationmaybecompoundedacrossthebankingindustry.Willshareholdersfactorinthemacroprudential componentintounderstandingrisks?

ØFundmanagersarewellknownforbeingpassiveinvestors– andactivisminbankingisdifficultandexpensive.

ØWillthiscreateincentivestogiveawideberthtomanagers?Isthereadangerthat,thelowerthevalueofthebankfranchise,themorepervasivetheincentivetorisksatcreditorexpense(e.g.correlationseeking,RichardSquire)(Dividends,Acharya).

ØCo-ordinatedactionpossible?

RisksEx-Post

• ThegoaloftheDFAandpost-CrisisrulemakinghasbeentogetridoftheTBTFproblem.

• However,thepervasiveappearanceoflargeblockholderscreatesdeeplinksbetweentherealeconomy.

• Thelossofequitycapitalintheeventofabankcollapseislikelytomakeadentinthevalueoffundsrepresentingaccumulatedretailandcorporatesavings.TheexerciseoftheOLAwillsimilarlyeliminateequityvalueintheeventabankfails.

• Thelossesmaybeespeciallymassiveispanicscreatemacro-prudentiallywideimpact,extendingtomarketinfrastructure.

• Arebailoutsinevitableifequityislikelytobeespeciallyhard-hit?

Solutions

SomeIdeas

• Corporategovernancedutiesforshareholders(see,DavidMin’sawesomepaper!)

• AgreaterfocusbyFSOCortheFedtopushshareholderstobemoreeffectiveguardiansofthecapitaltheysupply.

• Shouldlargeblockholderssetasidesomecapitalthemselvestobolsterthevalueoftheirfundsintheeventofabankingcollapse.Thiswouldreducereturnsyetfurther.

• CreateaprioritymechanismwithinCET1equitypool,potentiallyimposing lossesoninvestorsplacingtheirowncapitalatrisk,versusassetmanagersinvestinghouseholdcapital.Isthisworkable?Violatesequaltreatment?