July 06, 2012

How to break up a too big to fail and too big to capitalize bank... in hours!

Sir, Sebastian Mallaby is absolutely right about that the too big to fail banks must be broken up, ”Woodrow Wilson knew how to beard behemoths” July 5.

The largest problem though is that they are also too large to capitalize, as a consequence of the current capital requirements being too small for assets perceived as not-risky, but that are turning riskier by the hour, and which have left the banks with a contingency of extraordinary needs of capital. 

As a consultant I table the following break-up plan. 

First, decide that all resulting banks will need to have 8 percent in equity against any asset from there on. (See the Ps

Then create four management teams and have them, in turn, round after round, select 10 billion of assets belonging to Senior Mammoth Bank, until you have four Junior Mammoth banks. 

Then force all those who hold credits against Senior Mammoth bank in excess of 250.000 dollars to convert whatever percent of these is required to cause each of the four Junior Mammoth banks to have 8 of all assets in equity. 

And then let the market work swapping assets and pricing the final value of the breakups. 

If, there is a need for it, repeat the process again, for each of the four juniors. 

Ps. Mallaby writes “If the regulators impose a simple leverage ratio, measuring a bank’s capital against its assets, then they fail to distinguish between risky assets and safe ones, perversely rewarding banks that make the diciest loans.” He is stubbornly wrong. 

The difference between risky and not risky assets is already covered for in the interest rates, the size of the exposures and other terms, and so what the current risk-weighting produces, is an amazing distortion that allows the banks to earn (leverage) more on their equity, on what is perceived as not risky. That just dooms all our banks to end up gasping for oxygen and capital on the last officially perceived safe beach… perhaps, the US Treasury or the Bundesbank.

If you want to invest in a bank then you need to know that your capital injection is the last one needed… otherwise you are better off waiting for better opportunities. The regulators postponing bank capital increases into the future, thinking they are helpful, are just making everything so much worse, for everyone.