As the nation’s biggest banks stare down the barrel of sharply higher leverage requirements, they are reiterating that higher capital means less credit availability. So far, regulators have been wholly undeterred by this reasoning. Will it work any better now? I doubt it.
There are two fundamental problems with the more capital equals less credit argument that must be addressed even as the basic point – which is dead right – is reiterated. First, when capital was easy, credit flowed freely. But, much as a keg of cheap beer may be fun, but not exactly healthy, so low capital doesn’t necessarily mean less credit with resulting adverse macroeconomic impact. The recession in which we are still so deeply mired is in part the result of too much credit for too many borrowers from all of the lenders with too little constraint on their ability to make loans or hold MBS. If one is to make a credit argument about the adverse impact of higher capital on credit availability, it’s critical to connect the dots between higher capital and lower lending for borrowers with the borrower’s ability to repay, regardless of whether the borrower is a mortgagee, student, small business or giant corporation.
Secondly, the link between high capital and low credit comes a’cropper when one looks at which loans are now being made by whom. Sure, residential-mortgage credit availability is tight, but it’s critical here to differentiate funding capacity from interest-rate risk, secondary-market jitters, and the evolving qualified-mortgage framework. If one could isolate mortgage finance from these tough new requirements (none related to capital) and ongoing regulatory uncertainties, one could determine if mortgage credit scarcity for qualified borrowers is the consequence of higher capital. So far, I’ve seen no robust analytics parsing these critical variables. Thus, at best, we don’t know; more likely, mortgage credit will flow to portfolios and the secondary market when other risks are resolved.
In the absence of robust analytics, one can still tell the direction of credit availability for mortgages and other assets from two developments: the growth of “shadow” institutions and the higher-risk profile of the loans banks are in fact eager to make. Where does one see the shadow? In mortgages, take a look at increasing amounts of piggyback lending. Piggyback loans – a precipitating cause of the crisis – are loans where lenders load a twenty-percent second atop an eighty-percent first lien for a combined hundred-percent loan-to-value ratio (or a still higher one if the lender doesn’t stop at twenty percent for the second). In these loans, the first lien is sold to the GSEs and the second goes on its merry way, exposing borrowers to far greater risk in concert with those who haplessly hold the first mortgage. Couldn’t happen again after the hard lessons of the financial crisis? Call your non-bank mortgage company.
Is there a dearth of credit availability since banks won’t play this game? Maybe, but we’ve learned the hard way they shouldn’t.
What about bank loans? Here, one can see troubling signs of regulatory-capital arbitrage – this higher capital doesn’t impair credit availability when banks are willing to take risks that they think – hope – will lead to reasonable risk-adjusted returns. Leverage loans are flying out the door with longer amortizations and easier covenants – that is, at considerably higher risk.
Importantly, one reason for this trend is that much of the volume here comes from smaller banks exempt from the most robust risk-based capital and risk-management requirements. Sure, these banks are subject to leverage rules but, as I’ve said before, leverage without appropriate risk-based capital is just an invitation to find the high-risk sweet spot. Big banks do it in complex structured products with minimal credit-market impact; small banks do it the old-fashioned way, taking more risk than capital controls in hopes of making more money than the bank next door.
Does the fact that higher capital need not constrain bank lending mean that regulators can happily hike capital without fear? Of course not. First, banks aren’t the only players – as I said, shadow institutions are major providers of credit, and not just in mortgages. Look across the array of retail and wholesale financial markets and one sees major players outside the scope of the bank capital rules frolicking in an increasingly open field. Secondly, higher leverage capital a la Brown-Vitter creates a strong risk driver in which banks of all sizes balance between capital and risk. If they get this balance right, they are safer and only good loans get made – at least by banks. If they get the balance wrong because they’re diving over the side for an extra buck, we’re back where we started.