I knew that our new issue brief would be controversial, addressing as it does the hot-button question of the impact of capital regulation on credit availability.  However, as the reaction to our paper demonstrates, the capital-versus-credit debate is nowhere near as fired up as a kick-boxing battle when one asks – as we did – about the need for banks to make profits.  Although the capital question is most immediately on policy-makers action list, the profit-versus-purpose problem presents an even more profound, if existential question for the future of U.S. banks.  The higher the capital rules go, the more big banks become de facto utilities, chained to the mast of safety and soundness even as they face investor revolt over ever-lower returns.  Ultimately, something has to give.  If it isn’t the policy demands that inevitably erode profitability, then it will be the banks.

The link between the capital and profit questions is evident in influential BIS research.  In short, it argues that banks can handle credit generation without breaking a sweat under the Basel III rules if they simply retain earnings instead of distributing them to investors.  A recent New York Times article makes this case more politically, while a Washington Post piece earlier this week used gross revenue numbers to conclude that banks are raking it in and thus could lend without constraint.

The allure of this argument is inescapable:  plutocratic, profiteering bankers – the ones who wreaked the financial crisis – are now reveling in bonuses even as credit is scarce for those who could use it the most.  I’ll grant that credit is scarce for those who need it the most – that’s the reason FedFin went to all the trouble to release our brief.  And I’ll also grant that profit has a lot to do with credit scarcity even though the data used by those protesting profiteering banks are often dubious. 

The Post article is echoed in many recent blogs citing the seemingly overwhelming bottom lines posted by the FDIC for bank profitability.  Looked at instead in terms of return on equity – what investors get for betting on a bank – banks are about a third less profitable than they used to be.  In 2006, ROE was 12.3 percent; in 2016, it fell to 9.3 percent.  Seem about right to those who want “boring banks?”  Maybe, but it’s not only below the usual index for a bank’s cost of capital, but also well below what investors demand.  Just a year or so ago, we worked on a de novo bank charter and couldn’t get investors to bite because their minimum ROE is twenty percent. 

Banks are of course private companies owned by shareholders.  If shareholders aren’t happy, they vote with their feet, wallets in hand.  If shareholders drive down the market capitalization of banks, as an influential study last year showed clearly, then banks wither and die.  The nice thing about market discipline is that, bunted though it is due to various behavioral-economic phenomena and the odd big-bank rule, it’s still essentially ruthless.  If investors don’t get what they want from banks, they’ll move on in search of satisfactory returns from the next disrupter, a manufacturing firm, an emerging market, or a whatever.  That’s what investors do – they are nothing if not unsentimental, and rightly so.

In short, we can’t have publicly-traded banks without enough profit to satisfy investors regardless of what the BIS or others think ought to be enough for them.  This means that bankers maximize profit as best they can under whatever the rules demand of them.  Sure profits fatten their own paychecks, but profit-maximization is an inexorable law of the market jungle.

And here’s where the link between profit, the new capital rules, and credit scarcity is to be found.  When banks come under tough new capital rules, their equity capital must go up.  Profit is fundamentally measured by return on equity.  When the amount of equity goes up, its cost must go down (which it hasn’t) or the return will, holding the basic profitability of the business that generated the return as is.  The solution thus is to change the business model, usually by pushing up return to the greatest extent possible so that return on larger amounts of equity doesn’t sink so low below investor demand that the banks start down the road to market oblivion. 

Banks are thus now maximizing profit in the face of higher equity-capital requirements by walking away from the loans that cost them the most in terms of risk-adjusted return on capital.  Which loans fall below the profit threshold?  As detailed in our brief and demonstrated by the research we cite, it’s precisely the lending needed to support first-time homeowners, start-up small businesses, and other foundations of economic growth and individual prosperity.  Gross credit data – often used by those pushing back against the scarcity argument – mask this vital fact because much new credit is going to higher-yielding assets such as commercial real estate and even what leveraged lending banks can claw back from private-equity companies. 

Gross loan-origination data also mask the fact that huge balances in areas such as residential mortgages are then securitized to the GSEs or syndicated to yield-hungry investors – a critical way to reduce the cost of capital.  Loans for which there is an efficient secondary market thus grow, but not all loans have such markets and many of the loans that don’t are the ones most critical to income equality.  Prior and forthcoming FedFin research addresses this issue in more detail.

Will banks go gladly into the dark night (at least for their investors) of de facto utilities?  Of course not.  Community banks are well on the way to carving themselves out of this grim future and several of the largest, least traditional U.S. banks have another way out:  ring-fencing their traditional intermediation operations from the full sweep of finance housed elsewhere in the holding company.  Recall that Secretary Mnuchin described something like this during his confirmation hearing as the “21st Century Glass-Steagall Act” he envisions.  For many other U.S. large banks, a U.S. version of Vickers is a far-reaching franchise debacle, but for some it works very, very well.  In a sense, it’s a “can’t beat ‘em, then join ‘em” strategy because tough capital rules still apply to traditional activities, but profit no longer depends on any of these same old lending operations.

We shall of course see first if the Trump Administration advances something akin to this and then what Congress thinks of it.  However, a solution of some sort has to be found if U.S. banks remain in the inexorable vise of high capital rules and restricted business activities.  For some banks, this something will be death by a thousand cuts, for others it will be realignment into more and more businesses (e.g., wealth management) outside the scope of the capital rules, and for others it may well be de-banking.  Investors will demand nothing less from any of them even if prudential regulators don’t much care for what all their rules turn out to require.