One of the most interesting exchanges at a pivotal Senate Banking hearing yesterday came when Sens. Brown and Warren pressed regulators on bank capital distributions. Each alleged that banks – especially way-big ones – pay dividends and repurchase shares to enrich shareholders at grave cost to struggling borrowers. Sen. Brown went further, arguing that banks should be barred from capital distributions if profits come from regulatory relief. Given the capital windfalls that analysts project from recent Treasury recommendations, Democrats are laying pipe for a stiff price they hope to extract from any big banks that reap benefits from regulatory rewrites. Should they get it?
Capital-distribution restrictions are not an unprecedented act of untrammeled socialism. They are in fact a longstanding fact of life for public utilities. In a decades-old system, utility commissions countenance monopolies – indeed, they virtually ensure them – for critical public services such as electricity. Companies enjoying these monopolies are then allowed to return only so much of their not-so-hard-won gains to shareholders in the form of such predictable dividends that utility shares are suitable for the most cautious investor. Profits above and beyond those sanctioned by the utility commission are spent on approved activities such as low-income energy assistance, infrastructure improvement, and other pay-backs for the benefits that come with a utility charter.
The proposition Sens. Brown and Warren make is to convert the biggest banks from the de facto utilities they already are to de jure ones. CCAR, even as is, represents just one plank of the de facto utilitization of the largest U.S. banks – under it, covered companies must calculate capital distributions not by what the company thinks is a prudent business model or even what regulators stipulate as prudent under other rules. Instead, capital distributions are set by a stress-test model cooked up by the Fed staff. The model might be right, it might be wrong, but it governs banks just as inexorably as a public-utility commission either way.
De facto utility requirements are imposed now even though banks are anything but unregulated or insulated from competition. Big banks compete fiercely among themselves and with less regulated foreign banks as well as with lots of “shadow” competitors that run rings around them in all sorts of activities, especially those offering the highest profit potential – profit potential all the sweeter given that non-banks need not hold all the equity capital demanded of large banks.
Investors are agnostic – they might feel sorry for big banks strapped in a franchise-value vise that drives market capitalization down to or even below book value, but they won’t put any money where their tears might go. To invest in banks, investors want the same return they get by investing in say, a non-bank or a manufacturing firm. Investors want to earn something for the risks to which they put their funds and big banks must give them that something in the form of stock-price appreciation, capital distributions, or both. One might not want banks to answer to the calls of querulous investors, but investors have a pesky habit of wanting their money back plus more than a little something for their trouble. Fail to make investors happy, fail to get investors.
It’s thus clear that when banks can’t make enough money to warrant share-price appreciation, banks must make capital distributions if they want to stay in business. It’s actually relatively easy to answer the next “how much” capital-distribution question due to CCAR. We can dispute how CCAR is conducted and whether it has unintended implications – it does – but it’s clear that CCAR for better or worse sets a threshold at which capital distributions are most unlikely to threaten a bank’s safety and soundness. As a result, investors do not win at taxpayer expense.
Still, Sens. Brown and Warren argue that investors win at the expense of borrowers. Addressing this assertion requires first acknowledging that capital does fund lending along with other liabilities. The reason non-banks are often so much more profitable than banks is that they can use cheaper liabilities – e.g., wholesale debt – to fund loans that banks must back in part with lots more expensive equity. No equity, lots more return on what shareholders voluntarily choose to invest in light of likely risk; lots more capital, lots safer banks, but less investor return absent compensating earnings sources such as fee-based revenue.
As a result, bar banks from distributing capital and borrowers will be still worse off to the extent they still depend on banks. The more capital banks are required to hold, the more the business model has to change so that earnings remain robust enough to attract the investors a bank that wants to keep its lights on can’t live without. Some have argued that banks can holds lots of capital and still make lots more loans, but that’s only possible if banks retain earnings – a strategy sure to satisfy regulators at the expense of investors whose dissatisfaction will then ensure that regulators and resolution authorities have a still bigger problem on their hands.
Given these hard-nosed facts, any requirement that banks retain capital instead of distributing it to shareholders will kill off the banks unless there are viable lending opportunities readily at hand that make enough money to satisfy investors and at the same time comply with all the new rules. Some have argued that the market is replete with these opportunities but big banks disdain them in favor of plutocrat shareholders. Maybe so, but plutocrat shareholders actually want big banks to be viable profit engines over time, not short-term dividend or stock-repurchase machines. Banks aren’t utilities and they thus cannot sustain investor interest without a viable business model. Capital distributions support investor value, but they don’t create it – only year-over-year earnings generated by a real business model, not a profit-recycling system, can do that.
The real challenge before Congress and the Trump Administration as they confront financial reform thus isn’t how much capital banks should distribute, but how much they need to have to ensure safe and sound operation while sustaining viable franchises without the protection of publicly-ordained monopolies. We’ve had under-capitalized banks that earned too much money at too much risk, but now we’ve got over-regulated banks that make too little money to support franchise values much above their break-apart value unless they get out of the lending business for all but the biggest companies and wealthiest households. Either way, taxpayers lose in the end.