Recipe for Financial (In)Stability?

The Asymmetric Threat of Synchronised Recapitalisation

London, UK - 23rd April 2008, 23:15 GMT

Dear ATCA Open & Philanthropia Friends

[Please note that the views presented by individual contributors are not necessarily representative of the views of ATCA, which is neutral. ATCA conducts collective Socratic dialogue on global opportunities and threats.]

Recapitalisation has been the resonant word in capital markets this week as investors weigh up the benefits of Royal Bank of Scotland's GBP 12bn rights issue, Europe's largest ever stock offering to all existing shareholders. Banks going through a recapitalisation process are eager to repair their balance sheets. The numbers are staggering: the rights issue will be sold at a 46.3% discount to Monday's share price and will inflate the share count 60%. Further, the bank will cut its cash dividend per share. No wonder the shareholders are not happy. As a result, RBS's Tier 1 ratio of capital to total assets -- capital adequacy ratio -- will move from 4% toward 6%, but only after an additional GBP 4bn of disposals are made. Is this the way to go for the next round of bank recapitalisations or will institutional investors, in future, want preferred stock or high-yielding bonds (8 percent or higher) so that they stand first in the queue in the event of further negative events? If recapitalisation entails higher costs of capital than in the past, does this not mean lower profitability for banks in the future?

Confronted with continuing credit market turmoil and the potential for bank liquidity problems to evolve into systemic risk, the Financial Stability Forum (FSF), the Bank for International Settlements (BIS) in Basel, central bankers, and other national regulators appear to have agreed that all banks, big and small, need to strengthen their capital adequacy ratios significantly. This consensus was strongly reinforced by the G7 finance ministers and central banks in their Washington, DC, meeting about ten days ago. Recapitalising a handful of troubled banks may be considered manageable by financial markets, however, encouraging all North American and European banks to recapitalise at the same time, ie, in a synchronised way, poses challenges of an entirely different magnitude.

Yes, it can be argued that there is still large appetite among institutional investors for high-grade financial assets. It can even be argued that institutional investors like pension funds may have even greater appetite for quality financial assets now that they have stopped buying mortgage backed securities and other asset backed securities. However, what will investors make of a general recapitalisation of the entire banking sector of the Western World all at the same time? Does this not look like central banks are panicky and that the entire banking system is under severe stress? Public and private pension funds, mutual funds, insurers, hedge funds and other institutional investors must consider carefully the likely future profitability of banks. With the US already in what looks like a prolonged recession, and slowdown spreading throughout Europe and beyond to emerging markets, profitability of banks will obviously be adversely affected.

Beyond this short-term issue, investors also have to consider the longer-term impact on profitability for banks once central banks and other regulators are able to pose tougher capital requirements and more restrictive limits on leverage. The emerging international consensus among central bankers is that off balance sheet activities must become transparent and that extra capital cushioning should be provided for risks entailed in such highly leveraged activities. The International Accounting Standards Board is already drafting much stricter standards for reporting SIVs and other off-balance-sheet activities by banks. As observed by ATCA in its previous briefing "Enronitis Strikes Again?" off-balance-sheet vehicles have resided outside the view of both regulators and investors, but are now coming under scrutiny, revealing huge risk exposure far beyond anyone's recognition only a year or two ago.

Moreover, the emerging central bank consensus is that the entire process of debt securitisation must be reformed with stricter forms of due diligence, valuations, ratings, and visible identification of liabilities among sellers as well as buyers of securitised debt. Consider what this means to future profitability. In recent years, many banks have found the dominant share of their earnings outside the realm of spreads between deposit and lending rates. The large cap banks transformed into non-bank financial institutions, competing head to head with investment banks and brokerages, and even with hedge funds, in securitisation of mortgages and other forms of debt in an almost infinite variety of mortgage backed securities, CDOs, CLOs, and variants like auction rate asset backed securities. They also found profits not only in devising derivatives based upon these types of securities, but also in trading derivatives and Credit Default Swaps (CDSs) on a scale far larger than the total underlying capitalisation -- it is widely estimated that the size of the entire CDS market is of the order of USD 45 trillion, ie, more than two times the entire capitalisation of the US equity market. In other words, a dominant share of the earnings of banks and other large cap financial institutions is now derived from highly leveraged issuance and trading of securitised debt and other complex instruments. What the central bankers want is that risks in this highly leveraged market be dramatically scaled back. Can this be done without reducing future profitability? Taking into account the long-run likelihood of lower profitability for banks and non-bank financial institutions, will investors really be eager to pony up capital at present stock market valuations?

Federal Reserve Vice Chairman Kohn set out the Fed's view in an April 17th address: "All banks -- large and small -- need to consider whether they need greater capital cushions...Banks might find the current circumstances to be especially favourable for raising new capital. Not only would more capital provide a cushion against the sorts of unexpected declines in creditworthiness and asset values that have market recent months, it would also position banks well for expansion...." Kohn concluded that banks must place far greater reliance on longer-term funding. However, he observed that "Because these longer-term funding sources will tend to be more costly, both investment banks and commercial banks are likely to conclude that it is more profitable to operate with less leverage than heretofore. No doubt their internalisation of the costs of potential liquidity shocks will be costly to their shareholders, and a portion of the costs likely will be passed on to other borrowers and lenders. But a financial system with less leverage at its core will be a more stable and resilient system, and recent experience has driven home the very real costs of financial instability."

In other words, costs of funding will be higher, leverage will be lower, and profitability will be less in the future than in the fateful boom days of the financial markets of the last few years. What if investors recognise synchronised recapitalisation as generally unattractive, without extraordinary incentives such as increased spreads for new bond issues or extraordinary preferred dividends? The other option for banks under pressure to increase their capital ratios will be stronger efforts to reduce leverage. The result of vigorous deleveraging would be widespread credit contraction, which is historically the way in which economic weakness is converted into deep recession or depression. The problem of bank capitalisation would be converted into problems for the real economy. Consider the high dependence of small and medium sized businesses on banks: If these types of businesses cannot continue to expand, or even survive; we can expect new job creation to grind to a halt, and unemployment to continue to grow. In conclusion, if recapitalisation falters, or proves very costly, we should expect widespread deleveraging of financial markets.

Central bankers are already worried about the potential for a vicious cycle of credit contraction. Central bankers' demands for recapitalisation sound benign until one thinks through what this really entails for the future of the financial intermediation system as we know it today. Unless governments take on more of the risks, investors had better assume the worst, that the Great Unwind has only begun, and has a long way to go over the next several years.