Thursday, October 21, 2010

Banks Begin To Exhibit Consequences of New Regulations

Yesterday I wrote this post concerning David Malpass' recent insightful Wall Street Journal editorial, and his subsequent defense of it, if that's the right word to describe the one-sided conversation Malpass had on CNBC that day with the network's faux-economic reporter Steve Liesman.

My mind had more or less blocked out the details of that discussion, until I read two articles in yesterday's Journal concerning bank earnings and capital requirements.

The two articles concerned Goldman's recent earnings, which were down 40% from last year. It's not a big secret what happened. In the anticipation of the eventually-passed Congressional financial regulation bill, the firm trimmed its proprietary trading activities and began to keep capital more liquid, earning less, in reaction to the looming regulatory and capital requirement uncertainties.

Right underneath that article on page C3 in yesterday's Journal was one entitled Banks Confront Weight of Risk. That piece discussed the consequences of the new Basel III bank capital rules. In Goldman's case, the firm's CFO explained that regulatory capital would need to rise from $451B to $750B. Elsewhere in the article, it was explained that the new Basel rules increase capital ratios on risky assets, while simultaneously reducing the types of liabilities which are allowed to count as capital. One example of the first effect was an estimate that "Morgan Stanley's risk-weighted assets will jump 80% under the new Basel rules."

Any way you look at it, Basel III alone will begin to rein in decades of profligate, risky banking behavior by many firms which either were, or became, federally-backed institutions.

This isn't a bad thing, in my opinion. As I've contended in earlier posts, banking, in its totality, should never have become a growth industry. Sure, individual businesses, such as mortgage lending, consumer finance, or various structured instruments, might grow at elevated rates for short periods of time. But overall, banking is an economically derivative sector. It can't, in total, over time, grow faster than the economy it serves, without essentially taking more risks.

Again, as I've written in prior posts, there are and, now, will certainly be cases in which bank managers can't profitably deploy all the risk capital assigned to their positions, when capital costs are included in those profits. In short, properly risk-adjusted returns will fall, capital will shrink, and aggregate bank total returns will probably become appropriately more sluggish.

If anything, this regulatory change will push more risky finance business into the privately-held sector. Which, if you think about it, is a regulatory response to the decades-long trend of investment and commercial banks taking excessive risks while selling the ownership of such risk to the public. Looks like riskier financial business is headed back to private partnerships, as it was prior to the 1970s.

What does this have to do with David Malpass and yesterday's post?

Well, as my memory of his comments recovered, I recall his arguing that it isn't high interest rates that is holding back US economic recovery, but, rather, uncertainty on many fronts- regulatory, legislative, fiscal and monetary policy. In response, the economically unschooled Liesman repeated various platitudes about 'no double dip,' gradual recovery, etc., etc., etc.

Goldman's explicit statements about reining in activity in anticipation of greater regulatory burdens, the exact nature of which is as yet uncertain, supports Malpass' positions. Especially as they accompany such a precipitous fall in net income.

How's that for empirical evidence of an economist's contentions?

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