Monday, November 9, 2009

Lend more, but don't increase your leverage

How many times have you heard that banks have taken on way too much leverage. And that ended up causing the current crisis. Right? But no more. The US Congress is trying to put this into action. Under the "too big to fail" proposals, the largest banks should be prepared for higher capital requirements (thus lower leverage). The smaller banks are already significantly undercapitalized because of their real estate exposure and are trying to improve their capital standing before the FDIC shuts them down. They need to de-lever more by rebuilding their capital base.

So that's what banks have effectively done - they've deleveraged. The chart below shows the ratio of total loans and leases (commercial, industrial, real estate, consumer) to book equity for all the US chartered banks.

source: FRB

Banks have reduced that ratio since 08, keeping it fairly constant in the last 6 months. The overall bank leverage is now down, though maybe not as much as the regulators would like to see. Much of it was done through equity raises, retained earnings, loan sales, and reductions in lending. Looks like we are moving in the right direction, right?

But wait! Mr. Geithner now says banks have to lend more!
Bloomberg: U.S. Treasury Secretary Timothy Geithner is echoing billionaire investor Warren Buffett in telling banks “to take a chance again on the American economy.”

So far, his appeal is falling flat.

Banks are not listening because... maybe... they were told for the last 2 years to reduce leverage.

And Mr. Stiglitz, Columbia University economist adds that if the banks were taken over by the government, we could simply force them to increase their leverage by telling them to lend more.
“Bloomberg: If we had done the right thing, we would be able to have more influence over the banks,” Stiglitz told reporters at an economic conference in Shanghai Oct 31. “They would be lending and the economy would be stronger.”

Lend more, but be prepared for higher capital requirements. Take more risk, but don't increase your leverage. Extend more credit, but no "excessive lending". Which is it?

As the credit addicted US economy goes through it's withdrawal symptoms, is the answer really more credit? Certainly the US government thinks so and has shown an enormous commitment to credit expansion. But now it wants banks to follow along.
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