I wasn’t trying to sneak in an assumption of bimodality, I just wanted to go through the math for two relevant examples: 10% equity (where banks currently are) and 50% (where Cochrane wants them).
why is there so little demand in the middle?
I think there is − 11.2% is in the middle between 3% (the absolute minimum allowed) or the 6% pre-crisis and 50% (the highest non-joking suggestion). I don’t know (I don’t think anyone knows) whether 11.2% is the magic right number, but it seems to be in the right range especially compared to the extremes. But today all large banks are above the 6% average of 2007 and in the 8%-15% range (or 11%-17% if you’re looking at Tier 1 Cap / RWA) and their balance sheets got more stable and boring.
This is how the system works: the pendulum swings back and forth from boom to crisis and eventually settles on a good equilibrium (for many things, not just capital ratios). This post is mostly an argument against kicking the pendulum viciously in one direction or another.
I wasn’t trying to sneak in an assumption of bimodality, I just wanted to go through the math for two relevant examples: 10% equity (where banks currently are) and 50% (where Cochrane wants them).
But aren’t you doing that when you say “Perhaps shareholders will take a slightly lower return in exchange for a safer investment, but they wouldn’t take one-third.”? If the capital requirement was 50%, then sure the return for shareholders would be much lower, but so would their risk since the overall risk would be distributed over a much larger pool of equity. Why wouldn’t there be lots of shareholders willing to take that deal if preferences for risk/return wasn’t bimodally distributed?
Well, as a matter of fact it doesn’t seem like they do—they want 8%-15%. You could start a bank that promises to stay at e.g. 30% equity, but the market seems to indicate that you’ll have a hard time finding investors. Banks work hard to differentiate themselves since they ultimately offer very similar products, and I don’t know of any large bank that successfully differentiates by having high equity ratios.
Especially as in recent years investor preferences for lower risk, low beta, low vol, higher yield stocks (like utilities and staples) has been well documented as strong.
One related fact is that (at least some of the banks) feel like they haven’t gotten credit for the risk reductions they have done. Given their lower leverage now, they feel like they should have higher multiples, whereas actually their relative multiples have compressed vs the market vs pre-crisis. Of course, this may be because their risk was under-estimated pre-crisis, so their relative multiple was too high.
I wasn’t trying to sneak in an assumption of bimodality, I just wanted to go through the math for two relevant examples: 10% equity (where banks currently are) and 50% (where Cochrane wants them).
I think there is − 11.2% is in the middle between 3% (the absolute minimum allowed) or the 6% pre-crisis and 50% (the highest non-joking suggestion). I don’t know (I don’t think anyone knows) whether 11.2% is the magic right number, but it seems to be in the right range especially compared to the extremes. But today all large banks are above the 6% average of 2007 and in the 8%-15% range (or 11%-17% if you’re looking at Tier 1 Cap / RWA) and their balance sheets got more stable and boring.
This is how the system works: the pendulum swings back and forth from boom to crisis and eventually settles on a good equilibrium (for many things, not just capital ratios). This post is mostly an argument against kicking the pendulum viciously in one direction or another.
But aren’t you doing that when you say “Perhaps shareholders will take a slightly lower return in exchange for a safer investment, but they wouldn’t take one-third.”? If the capital requirement was 50%, then sure the return for shareholders would be much lower, but so would their risk since the overall risk would be distributed over a much larger pool of equity. Why wouldn’t there be lots of shareholders willing to take that deal if preferences for risk/return wasn’t bimodally distributed?
Well, as a matter of fact it doesn’t seem like they do—they want 8%-15%. You could start a bank that promises to stay at e.g. 30% equity, but the market seems to indicate that you’ll have a hard time finding investors. Banks work hard to differentiate themselves since they ultimately offer very similar products, and I don’t know of any large bank that successfully differentiates by having high equity ratios.
Especially as in recent years investor preferences for lower risk, low beta, low vol, higher yield stocks (like utilities and staples) has been well documented as strong.
One related fact is that (at least some of the banks) feel like they haven’t gotten credit for the risk reductions they have done. Given their lower leverage now, they feel like they should have higher multiples, whereas actually their relative multiples have compressed vs the market vs pre-crisis. Of course, this may be because their risk was under-estimated pre-crisis, so their relative multiple was too high.