Two Cakes

Eric Dash of DealBook reports on the latest stress tests conducted by the Federal Reserve, which apparently went swimmingly, at least for some of the healthier banks. I have no independent basis on which to assess the accuracy of those test results, so I won’t.

What I did notice is that JPMorgan Chase and Wells Fargo are using the green light from the Fed to start buying back stock: $15 billion for JPMorgan, 200 million shares (about $6 billion) for Wells. Does something seem wrong with this picture to you? Me, too.

Last summer, the argument from the big banks was that higher capital requirements were bad because they would reduce the amount of bank lending. The argument is pretty simple: Say you have a 5 percent capital requirement, $5 in capital, and $100 in assets, so you’re barely adequately capitalized. Then say your regulator increases your capital requirement to 10 percent. Now you either need to raise $5 more in capital or, since that could be difficult, you have to shrink your assets to $50 — which means you’re lending half as much money as before. The rules are much more complex than that, but that’s the basic concept. And, so the story goes, less lending means less economic growth means fewer jobs. Most infamously, the Institute of International Finance put out a “report” claiming that higher capital requirements would mean 9.7 million fewer jobs in the U.S., Japan, and Europe over five years.

But for this argument to even make sense, as many people pointed out at the time, bank lending would have to be constrained by capital at the margin. And the banks knew this was false at the time, because at the same time in other contexts they were saying that they were purposefully overcapitalized (e.g., Bob Diamond of Barclays saying his bank had 13 percent Tier 1 capital and almost 10 percent core capital). Now, this was not necessarily duplicitous at the time: the banks could plausibly say they were overcapitalized because of regulatory uncertainty — they didn’t know how high the capital regulations would turn out to be.

Well, now they know. To go back to our earlier example, it’s as if the banks had $15 in capital for $100 in assets because they weren’t sure how much the capital requirement would go up, and then the regulator said the capital requirement would be only 10 percent. So they have two options. They can expand the balance sheet up to $150 by borrowing $50 and lending it out (more lending = more growth = more jobs); or they can buy back stock. They’re buying back stock — that is, they’re taking $5 in cash from the asset side and using it to buy back $5 in stock from the liability side, leaving $95 in assets and $10 in capital – which is the same as saying, “we have more capital than we know what to do with.” Capital requirements could be 15 percent (in my simple example) and lending still wouldn’t be affected, because at the margin lending isn’t constrained by capital.

So it seems like the whole crusade against capital requirements was based on a fiction that’s been quietly dropped. I think that’s called eating your cake and having it too.

Originally published at The Baseline Scenario and reproduced here with permission.