Tuesday, February 15, 2011

Why Are Capital Requirements Hated By Banks?

Because they lower profitability—and therefore bonuses. Substantially.

Even the weak-kneed Basel requirements are having an effect, according to Bloomberg:
By cutting Credit Suisse Group AG’s profitability target last week, Brady Dougan acknowledged what some Wall Street bankers and investors are loathe to concede: Tougher capital rules will mean lower returns.
Dougan, the Zurich-based bank’s chief executive officer, lowered the goal for return on equity, a measure of profitability, to more than 15 percent from more than 18 percent. Barclays Plc said today it will aim for a 13 percent ROE, down from an average of 18 percent over the past 30 years. By contrast,Goldman Sachs Group Inc., the bank that makes the most revenue from trading, insists its target of a 20 percent return on tangible equity doesn’t need to be moved.
Profitability soared in the middle of the last decade as banks increased leverage, using borrowed money to bulk up on assets. The credit crisis exposed the risks of that strategy and resulted in $1.48 trillion of writedowns and losses worldwide. To generate the same returns while holding more capital, Wall Street firms can either discover fresh profit opportunities or reduce costs, including pay, analysts said.
A lot of fellow conservatives think that banking regulation and higher capital requirements are some sort of Commie plot. 

But the fact is, banks will always play roulette with the money that they are entrusted—especially corporate banks.

Private banks—where the partners are personally exposed to their bank’s losses—will never take foolish risks. Their lending standards will always be prudent, their leverage positions always cautious, because their partners know that they could wind up in the poor-house if they make the wrong bets. But the flip side to this sensible caution is, private banks will always be very hesitant to lend out money, and so will not help developing industries with financing. 

But corporate banks—apart from having access to greater capital through their publicly traded equity—will be more forthcoming insofar as loans to developing industries are concerned. Which is great—it spurs the economy. 

However, the flip side to that is, the people running corporate banks do not have a personal stake in the fortunes of the bank. So they won’t be so afraid of driving the bank into the ground—as happened in the period leading up to the 2008 Global Financial Crisis. 

That’s why capital requirements are necessary—and high ones at that. 

The lax capital requirements of the last 20 years have created an incentive to both take huge gambles with OPM (other people’s money), and give incentive to the banks to pay huge salaries to bank employees. 

Dougan is taking the first step in the new reality—let’s see if other bankers follow suit, or if there is enough push-back from the banksters that they get their way: A return to the wild-wild west days of yore. 

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