Why Politics Makes It Hard to Fix the Banks

Bank earnings season is under way, and with the financial results will come disclosures about average per-employee compensation that politicians seeking support for additional regulations or taxes on big banks will pounce on. Some of the proposals may make their way in some form into President Obama's financial reform plan.At the same time, the banks' decreased lending will be portrayed as a sign that banks are ungrateful to the American public for the generous bailouts they received -- and that they're unwilling to help restart the economy. Each of these arguments is based on a truthful data point.

Per-employee compensation at Wall Street firms will be several times higher than the average American earns, and credit offered by financial firms will be less generous. The problem is, proposed solutions to each issue with banks as they exist today tug at opposite ends of the same rope.

Unusual Forces

To paraphrase Abraham Lincoln, a reform effort divided against itself cannot be effective. It does, however, offer a good illustration of the challenges facing Washington, D.C., in trying to make economic stimulus self-sustaining.

Financial companies have several unusual forces acting on them. These can be grouped under the headings of "interest rates" (both borrowing and lending), "loan volumes," "regulatory capital levels" and "fee-based revenue." These are enormously important factors in determining whether or not banks make money, and each of them has become subject to increased uncertainty. Here, I'll touch on the three interrelated subjects.

First and foremost, monetary policy that promotes short-term interest rates of close to zero is not the free lunch proponents make it out to be. While attempts have been made to lower mortgage rates in particular -- and the spread between where current offered rates and a bank's cost of short-term funding are is sizable -- that analysis ignores that funding costs can vary widely over the life of an instrument like a 30-year mortgage.

Stockpiling Cash

In discussing why net interest margins at banks have lagged despite a record-wide yield curve, Rolfe Winkler says banks are simply stockpiling cash to avoid the risk associated with lending long-term at low absolute rates. Further, he notes, "[H]igher rates mean lower real-estate prices and higher default rates, which will continue to bleed bank capital.

It's a troubling paradox: Banks can't make money on new lending without higher rates, but higher rates will increase credit losses on old legacy loans. It's another reason the Fed is stuck.

The enormous savings on interest expense banks have received from the Federal Reserve's zero interest rate policies have been previously documented at DailyFinance; for example, Bank of America (BAC) saved $7.44 billion -- just shy of 50% -- in interest expense on deposits in 2009 compared to 2008, even as deposits increased nearly 14%.

Zero Interest Rate

Empirical observations suggest the main beneficiary of zero-interest rate policy is banks that need time to run off bad loans, not the economy as a whole. Looser monetary policy does normally serve to stimulate the economy. But -- as the Japanese experience testifies to -- when interest rates are at the zero bound, there are such imbalances within the economy that cause-and-effect in "normal" conditions no longer applies.

Rates are not set randomly, and (just like prices of any other good) send signals about supply and demand. The signal being sent now fits in with a McKinsey research paper finding that prolonged periods of deleveraging naturally follow major financial crises, as debts levels are lowered relative to gross domestic product. Interestingly, the U.S. government has fought the increase in private savings through deficit spending "effectively" enough that net national savings continues to trend negative, even as private savings have risen.

Another driver of a bank's ability to lend, and hopefully make, money is the capital the bank is required to hold. The more capital a bank needs to be "well-capitalized" according to regulators, the less leverage it can effectively take on -- meaning the fewer loans it can make.

Higher Capital Requirements

Higher capital requirements increase the cost of funding for banks. That's because equity capital has a higher expected return than depository funds. As a result, higher regulatory capital requirements mean that the interest rates banks offer on loans will be more expensive as well.

All of those are seemingly good reasons why lowering regulatory capital ratios would allow banks to lend more. Of course, banks with less capital supporting them are also much more prone to failure if they make bad loans. Adding to the complexity, the market meltdown from the fall of 2008 into the spring of 2009 also revealed that hybrid debt financing instruments that counted as capital, such as trust preferred notes, were not the equivalent of tangible common equity.

Banks essentially had both inadequate levels of overall capital, as well as expensive but useless quasi-capital (trust preferred notes from major banks currently yield close to 8%, an approximation of their pre-tax cost of capital). Through equity raising, most major banks now have exceeding high levels of tangible common equity relative to what is required to be considered "well-capitalized." This is good for bank safety, but bad for the amount of lending they can do.

Pendulum Has Swung?

Hedge fund manager Tom Brown believes that the pendulum has swung toward having banks be overcapitalized, writing that, "Regulators won't come out and admit they've moved the goalposts but, as multiple conversations I've lately had with bank CEOs show, they have. Now, apparently, it takes a 10% Tier 1 ratio to be considered well-capitalized, and regulators don't mind if banks are even a tad over that."

The historical precedent for this situation isn't hard to find. Former Fed Chairman Paul Volcker has complained that, "It simply doesn't make sense, as then Fed Chairman Mariner Eccles complained during the Great Depression, that the efforts of the Federal Reserve to ease money be to some degree frustrated by overzealous banking regulators determined to restore bank capital and assure strong lending standards." Rectifying banks' capital positions while maximizing credit availability isn't a new problem, and the natural give-and-take means that it can't be solved by edicts from inside the Beltway.

Although banks are on the receiving end of much political anger, they are stuck between a rock and a hard place with few, if any, easy choices.

Not the Enemy

The need to simultaneously recapitalize banks through profitable operations, shrink loan books as necessitated by unofficial higher capital requirements, and appear to be offering credit to consumers who are, on average, already over-leveraged, will continue to frustrate those seeking an expedient political solution.

Banks are not the enemy, and although many imperfections exist in our financial system, turning them into a target or a tool for recovery will end poorly. Over time, things will work out in the absence of counterproductive, even if well-intentioned, meddling.

James Cullen edits and writes at CollegeAnalysts.com. He is the vice president of the Boston College Investment Club, which owns BAC, but he has no personal position in stocks mentioned here.

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