HSBCÂ (HBC) CEO MichaelGeoghegan told the Financial Times that he expects international regulators will eventually require banks to have Tier One capital ratios of about 10%.
That’s significantly higher than the 8% target now going the rounds in conversations among regulators and bankers.
If Geoghegan is right, it means banks are going to have to raise a truckload of capital. And of the hardest to raise kind of capital at that.
If you’ve been worried that new rules will require banks to keep more capital in their vaults and that this would reduce their profitability going forward even after the recovery, then this is the stuff of your nightmares.
Raising Tier One Capital isn’t easy. You can’t just go out and borrow the cash you need to get your bank’s capital ratio back into regulators’ good graces. That’s because most kinds of borrowed cash don’t count as Tier One capital. The only things that do count are common stock,  disclosed reserves and retained earnings, and non-redeemable non-cumulative preferred stock.
So raising the bar on Tier One capital has a triple effect. It reduces bank leverage. Under a 8% rule, a bank could lend out $92 out of every $100. Under a 10% rule that would drop to $90 out of every $100.
It reduces bank stock dividends. Since retained earnings count as Tier One capital, banks will have an incentive to cut back on how much of their earnings they distribute as dividends.
And finally, it dilutes shareholders. If you owned shares in a bank that needed to issue new stock, your percentaqge ownership of that bank–and of things like its dividend stream–would fall proportionately to the amount of new stock sold to other investors. Let’s say you owned 100 shares of a bank with 1,000 shares outstanding. That means you own 10% of the bank. If the bank has to sell 100 new shares to raise Tier One capital, your 100 shares would represent only 9% of the bank post the share offering.
Banks are already on the lobbying warpath arguing that requiring them to keep higher reserves at a time when the global economy needs them to be doing more lending will jeopardize the recovery. So far that argument hasn’t made much headway among regulators who are almost as interested in restoring their public image as they are with the global economy.
I think the 8% figure will stick. But Geoghegan has raised the possibility that the outcome could be worse than anyone expects. I don’t think 8%, let alone 10%, is priced into bank stocks right now.
Just for the record HSBC is among the best capitalized banks in the world with a Tier One capital ratio of 8.8%. The bank did have to raise $19 billion from shareholders in a rights offering in April to get to that ratio.
You could argue the benefits as well. Bernanke would be able to follow his ZIRP for much longer than the market currently expects if Tier I was raised. These would be counteracting flation forces and could actually help the large and well capitalized banks.
Tightening up on the bank capital ratios rather than the interest rate would help keep loans affordable, add upward pressure on home prices, which hopefully lowers default rates, and maintain a nice spread and high profits. Smaller banks and those with lower capital will fail, and the big boys will gain market share.
One final note. According to the latest IMF Global Financial Stability Report, banks are still well undercapitalized. Also, earnings are not going to outpace loan losses for some time yet. So, it looks like it won’t matter whether Tier I is raised right away or later on down the road. We’ll see the same course of action: banks retaining earnings and raising capital.
Right now I don’t think the regulator or anybody in their right mind would want to do anything to derail this economic recovery. With that said, demanding banks to increase their tier one capital ratio by 25% (go from 8% to 10%) at this moment is economical suicide – bank would lend less and so less money for investment. Eventually something will have to be done to either minimize risk or provide cushion from the next economic blowout or a little bit of both. Let’s just hope that we don’t defer it too long and develop amnesia. Otherwise, this problem will be replayed again and hurting lots of innocent folks that are relying on the market for their retirement.
Nightmares indeed but, again sadly, worse than you might think because the fundamental business models of the banks and non-banks Financials are badly broken. That’s a huge statement. One you’ve poked at somewhat before in your regular column btw :). To expand a bit first toxic assets will need to be taken off the books (PPIP), then new capital will need to be raised, then the existing models built around three decades of excess debt and shoddy/shady business practices will need to be re-engineered to soundness and then banks will actually need to return to their returns and focus on creating customer value. We’re talking about a decade to reverse three decades of “malfeasance”.
If you look at each major line-of-business (wealth management, credit cards, business finance, consumer finance and finengr) the only source of profits recently has been the latter, all five LOBs are gov’t support dependent, when that AND leverage goes way the profitable (and therefore earnings power) goes down and the models in the first four have depended on chicanery; bait & switch, over-draft fees, surcharges, manipulating consumers into higher card charges & rates, penalties, etc. etc. That’s a lot to swallow so let me provide some backup but the bottomline is, IMHO, we’re headed into as fundamental a re-structuring of the basis of a major industry as we’ve seen in many decades. One way or another. Here’s a dissection with some backup detail that might put some substance behind those brief arguments:
http://www.scribd.com/doc/20018385/Facing-the-Firestorm-Finance-Industry-Popular-Anger-and-Reregulation