America has been dithering about how to sort out its banking crisis. The market has forced its hand. On the morning of Monday February 23rd a joint statement by banking regulators said that they stood “firmly behind” the banking system and would initiate promised stress tests of banks’ capital positions on Wednesday. The fine print remains critical and, so far, unclear, but the statement should at least halt the scary market moves that took place last week.
In a five-day period last week shares of two of the biggest and most vulnerable banks, Citigroup and Bank of America (BoA), fell by 44 percent and 32 percent respectively. Those of better capitalized institutions, such as JPMorgan Chase, fell by less. Far more worryingly, this sorting of the wheat from the chaff occurred in the credit defaults swap market, which showed the perceived risk of bankruptcy ballooning for Citi and rising sharply for BoA, while JPMorgan remained more secure. Investors seemed to be betting that new injections of straight equity from the state (rather than more dollops of preferred shares) would dilute existing shareholders, but also that the state might insist that a “haircut” be imposed on those further up the capital structure.
However emotionally satisfying, forcing banks to default on debt would cause the type of liquidity runs and market dislocation that brought chaos after the collapse of Lehman Brothers last year. The regulators’ statement seems designed to reassure on this front. What it still sidesteps is the basis on which new equity will be injected into tottering banks. Clearly the government could take all sorts of forensic decisions about the carrying values of assets that banks have on their balance sheets. But the market is mainly betting that the government will bow to common sense. Headline tier-one capital ratios show all three banks at 11-12 percent (with BoA including Merrill Lynch). But Citi and BoA have flattered these ratios with huge amounts of preference stock, much of it issued by the state.
This capital is not genuinely loss bearing: for example Citi can defer dividends on its latest government preference stock but not cancel them entirely in the same way as common shares. Strip out the hybrid capital and JPMorgan is at 6.4 percent. This is in line with the best capitalized European banks – for example Britain’s state-controlled RBS, even after it latest round of big losses, stands at about 7 percent. However Citi and BoA look much weaker, with ratios at about 3-4 percent as well as carrying higher investment banking exposure.
Investors appear only to trust banks with high levels of pure equity capital. That suggests it would be a good idea to convert existing government preference stock into pure equity. If this occurred at current market prices, the state would own about two thirds of BoA and about 80 percent of Citi. But instead the regulators’ announcement on Monday appears to support the idea of more “temporary” preferred shares that would convert into common stock “over time” as and when losses materialise. This further fiddlyness seems designed to avoid the appearance of nationalization, but it could well create even more confusion about the true loss bearing capacity of these two firms, and of other banks that are likely to fail the test. It is hard to believe the solution to banks’ problems is to make their capital structures more, not less, complicated.