Morgan Stanley Speaks: Against Relying On Capital Requirements

Just when momentum was starting to build for increased capital requirements as the core element of an approach that will reign in reckless risk-taking, Morgan Stanley (MS) effectively demolishes the idea.

In “Banking – Large & Midcap Banks: Bid for Growth Caps Capital Ask,” (no public link available) Betsy Graseck, Ken Zorbo, Justin Kwon, and John Dunn of Morgan Stanley Research North America dissect the coming demands for more bank capital.

“In short, we think the demand for growth and access to credit will trump desire for unprofitable capital levels…

For the large cap and midcap banks, we expect normalized median common tier-1 ratios to come in at 8.4% and 10.0% respectively.”

That’s less capital than Lehman (LEHMQ) had just before it failed – 11 percent.  (If you doubt this, read the transcript of the final Lehman conference call – link is in this NYT.com piece or try this direct link; see p.7, for example)

The Morgan Stanley logic is strong, up to a point – they are carefully anticipating the likely outcome of the national and G20 regulatory process that will address capital standards in detail over the next two years.  This research report also makes explicit a great deal of the current thinking on Wall Street and explains much – including the attitude towards bonuses.

“Banks need and investors require banks to earn a positive return over their cost of equity to fund them…

These capital levels [8.4% and 10%]  driven median ROE [return on equity] estimates of 13.7% and 12.0%, sufficiently over normalized cost of equity of 9-12% to attract investors.”

In other words, if you don’t allow banks to leverage (the flip side of keeping capital low), they won’t be able to attract investors and won’t be able to make loans – so you’ll get less growth and fewer jobs.

This may sound like blackmail but it is not – this is the economics of banking, with spin.  And just to make sure you get their bigger point, Morgan Stanley drives it home:

“Contrary to perceptions about [Sheila] Bair’s statements, we do not think there is any willingness to remove implicit support [for big banks].  In particular, we expect the discount window is unquestioned for banks, and TLGP [Temporary Liquidity Guarantee Program] type programs could exist in future crises.  Regulators recognize the need for banks to make returns high enough to attract capital.”

And in case you are wondering about the talking points they give their lobbyists and now press upon the White House,

“Even with appropriate leverage, the taxpayer has occasionally paid for the benefit of growth when financial shocks occurred.  Repayment comes with subsequent growth.”

The bottom line, translated: let us adjust our balance sheets (downwards to some degree) and continue with our existing business models (including unconstrained bonuses), and we will bring you back to growth eventually.  If you mess with us, unemployment will stay high for a long time.  And any future crises that may befall us are just a cost of doing business, and making us whole is just what you have to do.

But this is all wrong.  The essential premise of the Morgan Stanley reasoning (heard much more widely on Wall Street) is that the size of our biggest banks cannot be constrained – because it would raise the cost of equity for these smaller units.  This misses three points:

• If you are sufficiently small, you can take more risk without jeopardizing the system.  So the expected risk/return combination can attract investors and be fine for society.  Most successful venture capital funds, hedge funds, and private equity funds are in the right size range from this perspectives and don’t have trouble attracting capital – except when the big banks blow up.  As long as you are small enough to fail, go for it.

• Morgan Stanley’s pricing of risk model implicitly assumes that big banks still exist as a comparison point and an alternative for investors.  But if you put a size cap on the largest banks (e.g., assets cannot exceed 1% of GDP), this defines the asset class available – so investors don’t choose small vs. medium vs. large; they choose small vs. medium.  Yes, this removes a choice for investors, but we routinely constrain investors ability to put money into activities that are potentially dangerous for society (e.g., try proposing a “new” high risk/high return approach to nuclear power).

• There will always be financial shocks, but these do not always need to have such devastating effects.  Our financial system worked fine in the post-World War II period, with a great deal of risk-taking and much nonfinancial innovation – our biggest banks were much smaller, in absolute terms and relative to the economy.  The notion of “let us take any risks we want and, if it all goes bad, bail us out so we can make it up to you later” is simply preposterous and completely at odds with the historical record of US economic development.

The big banks’ bonuses undermine their legitimacy.  Every time these banks CEOs speak or write in public, they just underline their hubris and the danger this poses to financial system stability.  And their own research strengthens the case for breaking up the megabanks.