Bank Capital and Unintended Consequences

With some level of disclosure of the results of the special “Stress Test” by regulators looming, a number of related questions are likely to occupy the market: What banks need additional capital: who will provide that capital; what are the consequences of raising the capital?

University of Chicago Professor Raghuram Rajan suggests a regulatory framework for bank capital that would avoid the pro-cyclical behavior of the existing system. In a recent article in The Economist he explains how such a system would work. He argues that such a system needs to meet “the three Cs” test. It must be comprehensive, that is, apply to all leveraged financial firms; it must be contingent, come into force when a financial firm is “most likely to do itself harm;” and it must be cost-effective.

The current approach fails to meet any of these “C” tests. A Bloomberg News article, “Stress Tests May Force Banks to Convert TARP Stock,” points out that converting government held preferred stock issued under the TARP may be the only viable alternative for banks to raise additional capital. Thus, the government has come to be not only the “lender of the last resort” (through the Fed), but also an investor of the last resort (through the Treasury).

The ownership stake by the U.S. Government, where departments within the U.S. Treasury and the Fed regulate banks and other financial institutions, pose serious dilemmas for the market to decipher. Bank of America CEO, Kenneth Lewis, testified to New York Attorney General Cuomo that the Treasury and Fed told him not to terminate the Merrill Lynch acquisition in the face of steep losses and not to disclose those losses to his shareholders (and the public). Such pressure is especially destructive to the ability of finance companies to raise private capital. Mr. Lewis’ dilemma is likely to become a case study for business ethics classes: what is the “right” decision when the regulator essentially instructs you to violate securities laws? The regulators clearly subscribed to Col. Jessup’s view which he forcefully expressed to Lt. Kaffee in A Few Good Men, “You can’t handle the truth!” The results of the bank stress tests to be released during the week of May 4th will again demonstrate how much truth the regulators feel the financial markets can handle.

Even if strong banks who need no additional capital succeed in purchasing the preferred shares back from the Treasury, warrants issued with the preferred guarantee that a government ownership stake could still remain. Repurchase of those warrants will require further negotiations, as pointed out in another Bloomberg News article.

Former Labor Secretary Robert Reich, in an editorial piece in the Wall Street Journal, raised dilemmas, among them: If the Federal government owns a significant share of a bank (or any company), it “should be represented on that companies’ board of directors in direct proportion to the size of its stake,” and those public directors should be “appointed by the President.” Mr. Reich also posed a troubling question for shareholders: Given that the government owns a stake in a bank, is the CEO’s “main job still to make money for his shareholders, or does he now have a higher public responsibility to lend more money to Main Street?”

Thus, the dilemmas facing financial company CEOs, regulators, and the markets will not ease for the foreseeable future. Recapitalizing the banking system is getting messier. As Henry Kravis, a co-founder of Kohlberg Kravis Roberts & Co., recently pointed out, “We do not know about the terms” of government intervention, nor do we know whether investors are “going to be called into Congress because you are making money.”

Bob Decker, CFA