Tuesday, August 24, 2010

The Problem with Bank Regulators

FDIC Sheila Bair’s Commentary Reveals Serious Weaknesses Richard X. Bove

Vice President Equity Research
Financial Sector
rbove@rochdalesecurities.com
813.909.1111

Lack of Understanding of Capital: What It is and What It Does

Sheila Bair, the Chairwoman of the Federal Deposit Insurance Corporation (FDIC), wrote a comment for today’s Financial Times. This
comment demonstrates clearly why the banking regulators are incapable of dealing with a financial crisis that they helped create.
The core problem is that Ms. Bair does not understand that bank capital is intertwined with the economy and that the safest and
soundest banks are created when the economy is growing not when the banks are over capitalized. Her prescriptions for the
industry fail to take this fact into account and could be the source of more banking problems if they are heeded.
Ms. Bair’s Position
Ms, Bair was selected by President George W. Bush to chair the FDIC for a five year term on June 26, 2006. Her appointment allows
her to stay on the FDIC’s Board for an additional two years once her appointment as Chairwoman expires. Ms. Bair was, therefore,
in office two years before the financial crisis erupted in the fall of 2008. It is fair to state that nothing that she did in that two year
period helped to either alleviate or avert the crisis even though she had substantial powers, which if used, could have helped
alleviate the problem (but not avoid it).
Unlike the heads of the Federal Reserve (FRB) who have repeatedly acknowledged their failure to act before the financial crisis, the
FDIC has never done so. This raises the question as to whether the FDIC realizes what it did that was wrong. Ms. Bair’s commentary
almost seems to argue that the FDIC knew what was wrong but did nothing about it.
Point
Ms. Bair’s core argument is that “excessive leverage was a pervasive problem that had disastrous consequences for the economy.
When banks and other financial institutions got into trouble many of them did not have a sufficient equity cushion to weather the
storm. This paved the way for major market disruptions, taxpayer bailouts, and massive contractions of credit.”
Counterpoint
Ms. Bair fails to explain why the banks were so leveraged. She has not connected the buildup of large concentrated
holdings of funds globally to what occurred in the U.S. banking industry.
Moreover, she does not indicate that the FDIC had the power to force the American banks to reduce their leverage but she
chose not to use this power prior to the crisis.
She does not distinguish between bank holding companies and non-banks in making her case. This is a critical point
because the biggest problems in the financial system arose outside the banking system not in it.
She persists in using the term bailout without acknowledging that the banks did not use the bulk of the funds that were
invested in the industry by the government. This money was deposited in the Federal Reserve. Moreover, the bulk of the
funds made available to the banks were paid back at a sizable profit to the government. The government funds were used
to shore up confidence in the system not bail it out.
Point
Ms. Bair argues that “Thankfully, the Basel Committee on Banking Supervision is now moving to correct the problem. Proposed
reforms centre on three areas: weeding out hybrid instruments, which confuse debt and equity and weaken the capital structure;
adding new capital buffers so deleveraging will not crush lending in a crisis; and placing higher capital charges on riskier derivatives
and trading activities.”

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 Tuesday, August 24, 2010
The Problem with Bank Regulators
Counterpoint
Presumably Ms. Bair is referring to trust preferred securities when she mentions weeding out hybrid securities. The
question arises again, that if she did not believe in these securities why did the FDIC allow banks to issue so many of them?
Moreover, why were smaller banks allowed to use this instrument as a core source of building capital? Further, if these
instruments are to be eliminated, as is now the law, what is going to replace them?
The failure to come up with a type of capital that banks can sell to replace trust preferreds will force many small banks out
of business. This article does not raise the “too big to fail” issue, but the elimination of trust preferreds will result in the
elimination of many of those banks that the government wants to rely upon – i.e., the community banks.
Ms. Bair fails to realize that deleveraging is not the main cause of lending failing in a crisis. Bad loans are. When bad loans
are written off they reduce capital and increase leverage. The job of the FDIC is to try to prevent the banking system from
making bad loans. They did not do this. Moreover, at no point in her discussion does Ms. Bair indicate that she
understands the impact that bad loans have on the banking system or the responsibility to, as ex Fed Chairman William
McChesney Martin said “Take the punch bowl away just when the party gets going. “ Ms. Bair and the FDIC did not do that
and now want to write a number of rules that will cripple the system.
The desire to reduce the so-called riskier trading activities and derivatives begs the question as to what these are, that are
harming the system. No study has been produced that I am aware of that shows why the derivatives market is so huge.
Why is this market so big if it serves no purpose? No one has explained this. It may be discovered that the problems in that
market are related to bad lending practices not the structure of the markets themselves. Yet, the desire is to harm the
structure of the markets without explaining what these markets do.
Point
Ms. Bair points out that a trade industry report suggests that the new bank capital rules will raise the cost of funds to the banking
system by 132 basis points, causing a loss of 3.1% in gross domestic product, and 9.7 million jobs between 2011 and 2015. She
questions the validity of that study pointing to similar studies from Harvard, the University of Chicago, and the Bank for International
Settlements that suggest minimal impacts on the system from a rise in capital ratios. The difference in opinion, Ms. Bair writes, is
due to:
First, a misunderstanding as to the true cost of tax deductible debt (it is higher than the trade industry says it is), and
Second, the social costs of a bust which are higher than what is being considered by the trade association.
Ms. Bair then goes on to describe how capital was misallocated to the property markets rather than industrial markets prior to the
bust.
Counterpoint
I cannot comment on studies I have not seen. The point here is that the issue is not the cost of funds. The issue is the
availability of funds. Banks are now selling at below book value indicating that equity is not available at reasonable cost to
the industry.
Second, forcing banks to raise capital in this environment raises the cost of funds meaningfully and this was not discussed.
Further, it was not indicated that if banks are unable or unwilling to raise capital in down markets that they have a second
option to meet their capital requirements. They do this by shrinking their balance sheets. This causes money supply to
decline and this weakens the economy. Ms. Bair has not even thought about this.
It is shocking that Ms. Bair would argue that too many funds were allocated to the property markets. It is almost a Kafka
like statement as if she was an outsider or a bug on the wall looking in as opposed to someone in the middle of the process.
The FDIC/Ms. Bair, should absolutely have stopped this misallocation of funds and did not do so. To blame someone else
for a lapse that was also made by the FDIC is not justified.

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 Tuesday, August 24, 2010
The Problem with Bank Regulators
Point
Ms. Bair ends her commentary with remarks concerning how beneficial it will be to force more capital into the banking system. She
writes again about “aligning incentives and internalizing the costs of leverage and risk taking.” She attacks bankers for having self-
interest and she believes that lower returns on equity and lower incomes are an acceptable result of adding capital.
Counterpoint
Ms. Bair does not understand that there is a relationship between return on capital and raising capital. She apparently
believes that investors will be attracted to put new money into companies with deteriorating returns. This is in concert
with her belief that raising money at below book value makes sense.
Additionally, despite the fact that bank CEOs make much less than their peers in the industrial world or people in the sports
or entertainment sector, she believes bankers should make even less. Again, there is a failure to understand that people in
the commercial world are driven by a profit motive and that the best and the brightest will not be attracted to the industry
that pays least.
Moreover, Ms. Bair does not believe that companies or individuals should be motivated by self-interest.
At the core, Ms. Bair is demanding more capital in the industry without stating any concept as to what is too little capital
and what is too much capital. The American banking industry now has more capital as a percent of assets than at any time
since 1935. The question as to why more is needed is not answered. The point that too much capital reduces bank lending
and money supply is ignored. The fact that a declining money supply is associated with a declining economy is not
considered.
Core Problem
The core problem with Ms. Bair’s article is that it assumes that capital is available in unlimited supply and that investors are not
influenced by the return on equity in making investments. There is no understanding as to the impact of heightened capital ratios
on bank lending, money supply, and the economy. The fact that banks are made healthiest by a growing economy and not by
growing capital ratios is not understood.
There is a total failure to adopt responsibility for the failings of the regulators and the part they played in creating the financial crisis.
At a broader level, there is no understanding of the global factors that influence the industry. Articles like this one only deepen the
belief of investors that the government is simply out-of-touch with the real factors that influence the economy. It is tragic.

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 Tuesday, August 24, 2010
The Problem with Bank Regulators

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 Tuesday, August 24, 2010
The Problem with Bank Regulators

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RR RATINGS DISTRIBUTION
BUY 23
HOLD 48
SELL 29

RATINGS FOR STOCKS

Buy Company has demonstrated that it is a value creating concern; the return on capital (as adjusted) exceeds its cost of
capital. Stock is currently trading in a range that does not exceed its intrinsic value. Stock is expected to out-perform the market
over the next twelve months.
Hold/Neutral Company either is not creating value (i.e., its costs exceeds its return on capital) or it is trading at a price equal to
or in excess of its intrinsic value. Expectation is at best stock will perform in-line with market. If not currently held, the stock
should be avoided.
Sell Company's cost of capital exceeds its return on capital; and the company has no intrinsic value or is trading at a significant
premium to its intrinsic value. Expect stock to under-perform the market over next twelve months.

ANALYST CERTIFICATION
I do not hold any securities of the company covered by this report.
I certify that with respect to each security or issuer that I covered in this report; (1) all of the views expressed accurately reflect
my personal views about those securities or issuers; and (2) no part of my compensation was, is, or will be, directly or indirectly,
related to the specific recommendations or views expressed by me in this research report.

-- Richard X. Bove

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