Following up their recent analysis of risk in the banking system, DeMarzo, Jiang, Krishnamurthy, Matvos, Piskorski and Seru argue that banks should be required to promptly raise equity capital in order to reduce fragility and provide a needed market test to identify truly insolvent banks. They estimate that amount of private capital needed is in the range of $190 to $400 billion.
The current monetary tightening episode has revealed unanticipated fragility in the banking system, narrowing the path for policy makers attempting to tamp inflation while avoiding more severe economic dislocation.
From the start of the Covid-19 pandemic in March 2020 through March 2022, the economic slowdown combined with monetary easing and large fiscal transfers increased total deposits at commercial banks by over 30%. This unprecedented growth in bank liabilities led to corresponding asset growth, largely in the form of tradable securities including longer-term treasuries and mortgage-backed securities.
As interest rates have risen dramatically over the past year, the market value of bank assets have fallen. Given the maturity mismatch between bank assets and short-term deposits, the net effect has been an erosion of bank solvency. Across the banking system, Jiang et al. (2023) estimate the mark-to-market losses on the reported duration of bank-held securities and loans alone to be $2 trillion. While a full accounting of these losses has been avoided by banks ability to maintain held-to-maturity assets at their book value, there is no avoiding the economic reality that the true value of equity capital in the banking industry has fallen by at least this amount.
These reductions are unequally distributed across the system, with some banks being particularly hard hit. Figure 1 plots the distribution of the equity/asset ratio across the 4800 banks in the U.S. banking system. The entire distribution shifts to the left from 2022Q1 to the present, based on the Jiang et al. (2023) estimate of marking bank assets to market. 2,315 banks – accounting for $11 trillion of assets in aggregate – fall below the 0% line in figure 1.
The important implication of this analysis is that the recent fragility and collapse of several high profile banks is not an isolated phenomenon. Nearly half of U.S. banks could face similar difficulties if forced to liquidate a significant fraction of their assets in the wake of large deposit withdrawals.
That said, the mark-to-market test reflected in Figure 1 is a component of solvency, but is not determinant. Banks have franchise value that is not reflected in the value of the securities and loans they own. Thus it is likely that a large fraction of the 2,315 banks in the figure are solvent on a long-term basis even after the interest rate shock we have experienced.
The Current Policy Challenge
The creation of the Bank Term Funding Program together with the implicit extension of deposit insurance to all depositors has put a pause on the crisis and reduced the risk of acute deposit runs across the banking system in the short run.
Narrowly, in the case of SVB and other recent bank closures, the government’s action has avoided moral hazard. The owners of the bank, whose decisions have led to bank failure, have been wiped out and the bank’s assets will be sold to new owners.
However, the government’s actions have amplified moral hazard for every other bank in the system. They have implicitly insured non-insured deposits, and the BTFP provides partially unsecured loans, since these loans are under-collateralized. Finally, both the discount window and the FHLB have extended loans to banks at generous terms. The government’s overall exposure to the banking system has therefore greatly increased. In the near term, the banking system’s reduced equity position can trigger a credit crunch in a repeat of the 2008 financial crisis, while over the longer-term the moral hazard of the government backstop can lead to imprudent lending as in the 1980s Savings and Loan crisis.
The critical question facing the Fed and Treasury is therefore to assess the true economic solvency of the banks it is supporting. The classic Bagehot dictum of lending freely against good collateral prescribes providing liquidity to avoid a run on a solvent bank, while not providing liquidity to prop-up an insolvent bank. The latter is the achilles heel of government backstops, leading to the problems of moral hazard, zombie lending, and regulatory forbearance.
How can the government avoid the calamitous path taken all too often of regulatory forbearance, as in the Savings and Loan crisis, the Japanese banking crisis, and the European debt crisis?
Economic solvency requires a market test. The ability to raise new equity or long-term unsecured debt from outside investors is a market test that draws a clean line between solvent but illiquid and insolvent. In addition, new capital inflows will reduce fragility and restore “skin in the game” for these institutions.
We therefore propose the following policy actions:
- Restrict equity payouts for the foreseeable future. While not a direct market test, this will preserve capital within the banking system and reduce moral hazard.
- Tie continued access to government lending facilities, including the BTFP, the discount window and the FHLB, to increased equity. Within 90 days of accessing the facility, the bank must initiate a capital raise in order to maintain access to the BTFP.
- Couple all additional support and regulatory forbearance to a general increase in capital requirements for the most affected banks.
The equity raise is the heart of our proposal. As noted, it is a market test that identifies truly insolvent banks. The alternative to this broad-based equity raise are one-off resolutions of failing banks, as the government has pursued in the case of SVB, Signature, and First Republic. From our analysis, the number of banks currently in the danger zone numbers in the thousands, so that repeating this approach is simply not feasible.
Raising equity capital now will also be less disruptive to the economy than having a large number of small and medium sized banks fail. Resolving SVB already has required an asset sale on the order of $100 billion. As the number of banks in this situation grows, this number can easily run into the trillions of dollars, and working through these resolutions can take years as in the S&L crisis.
Sizing the Problem
As we compute next, an equity raise right now will require an infusion of private capital in the range of $190 to $400 billion.
We assess the required level of capital as follows. For each bank i, let Di be the total level of deposits and FHLB loans. Let kbe the desired level of coverage of these liabilities (“coverage ratio”). Given book assets Ai, and mark-to-market losses Li, the required additional capital, RCi, for bank i is given by
RCi(k)= max[0, (1+ k) Di- (Ai- Li)]
Note that when the coverage ratio k is negative, the bank’s current mark-to-market assets are insufficient to meet its deposit claims and existing FHLB loans; that is, the government would incur losses in the event of a run.
Figure 2 uses the same data as in Jiang et al. (2023) and shows the number of banks below each coverage ratio k (i.e. those with RCi(k)>0). For example, approximately 1900 banks have a coverage ratio below zero — the mark-to-market value of their assets is below the level of existing deposits and government-backed loans. Of those, about 1000 banks have a mark-to-market shortfall (negative coverage) of more than 4%. As noted, one-off solutions as in the case of SVB, Signature, and First Republic are not viable for this number of banks.
Figure 2 also shows the total capital infusion required to restore a given coverage level (the sum of RCi(k) over all banks). To get all banks above zero would require $189 billion in total capital, an average of $98 million per bank. Raising the level of coverage to a modest 5% would require roughly 3200 banks to raise an average of $127 million each for a total of approximately $400 billion in new capital.
To provide some context, $189 billion is not a large number relative to the available supply of risk capital. For example, the amount of dry powder in the private equity industry is over $3 trillion, and indeed the financial press reports that some of this capital had been actively evaluating the loan book of SVB. Furthermore, the amount required to improve a given bank’s capital position is much smaller than the amount required to resolve all of the bank’s assets, as would happen in an FDIC bank resolution. Resolving all the banks currently in the danger zone by selling assets would require investors to absorb over $2 trillion of assets.
Jiang, Erica; Gregor Matvos, Tomasz Piskorski and Amit Seru. 2023. “Monetary Tightening and U.S. Bank Fragility in 2023: Mark-to-Market Losses and Uninsured Depositor Runs?”, Working paper available at SSRN: http://dx.doi.org/10.2139/ssrn.4387676
Raising Capital vs Raising Capital Requirements
Our proposal calls for raising capital to address mark-to-market losses, rather than raising de jure capital requirements which are accounting based and may still be satisfied for many troubled banks. (Note that risk-weighted capital requirements do not reflect the interest rate risk inherent in long-term government bonds.)
The amount of capital raised should be assessed by regulators on a bank-by-bank basis. The outcome of this analysis could be a capital raising plan, which involves some mix of profit retention and new capital.
Why not stop raising/lower interest rates?
The Fed is raising interest rates to rein in inflation. The losses in the banking sector are caused by these actions. But it does not follow that a better strategy would be to give up on inflation and prioritize avoiding bank losses. The cost of inflation is commensurate in size to the entire $20+ trillion U.S. economy, while our computations indicate that the banking sector fragility can be avoided with a capital raise of a few $100 billion.
This simple cost-benefit analysis indicates that policy should ensure banking sector stability while continuing its focus on inflation. Last, this computation also indicates that it could be efficient for the government to put in place additional financial incentives for banks to raise equity capital, possibly with government investments in preferred equity.
A voluntary equity raise is likely to be viewed as a negative signal by the market (as in the case of SVB). To avoid such a stigma, it is important that the required equity raise be made across the board and contingent on generally available information. In this way it will not provide a new negative signal for the affected banks.
We suggest a mark-to-market “stress test” along the lines of the basic analysis described here to set the new capital raise for individual banks.
Will requiring an “Equity Raise” reduce lending?
Our proposed equity raise depends on balance sheet losses that have already occurred, and so will impose no direct cost on new lending. Conversely, by boosting available capital, this proposal should enhance lending capacity.
It is also worth noting that raising standard accounting-based capital requirements would instead be likely to provoke a credit crunch by tying new lending activity to additional capital requirements. This is why our proposal emphasizes raising capital not raising capital requirements.
Isn’t patience a better strategy?
While it is tempting to wait for affected banks to resolve on their own, there are important downsides to this approach:
- Banks remain extremely fragile to deposit losses and dependent on government support.
- Given their current debt overhang, banks will find it attractive to reduce new lending and/or increase risk-taking, potentially exacerbating the crisis.
- Banks that attempt to resolve the debt overhang on their own will be subject to negative stigma effects and so may be reluctant to do so.
- A number of regional banks have loan exposure to commercial real estate and might experience additional stress. This is an asset class that is likely to experience turmoil over the next few years [see this analysis (link)]. It is important that regional banks maintain strong balance sheets to avoid any systemic risk from the commercial real estate sector [see this analysis (link)].
Why is a “Market test” needed?
On a mark-to-market basis, a large number of banks are technically insolvent in the sense that their existing assets do not cover their outstanding liabilities to depositors and government-backed loans. That said, they may have sufficient franchise value – stemming from their ability to generate future profits – to much more than offset this gap. Equity (or junior creditors) will have the best ability and incentive to assess the potential franchise value. Those for whom it is sufficient should be able to raise new capital at reasonable terms.
Conversely, those banks who fail this test are both technically and economically insolvent. Allowing them to continue is likely to exacerbate the problem as they will be tempted to take on excessive risk to “gamble for resurrection” at the government’s expense (as occurred in the second stage of the S&L crisis).
Raising Capital vs Regulation
The alternative response to raising capital is new micro-regulation of bank activity to avoid the negative consequences of debt overhang.
Our approach is instead to restore adequate “skin in the game” for solvent banks and more quickly resolve those that are no longer economically viable. The end result will be a more robust and competitive banking system, avoiding years of potential stagnation and fragility.
Articles represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty.