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After
a
year
of
occupiers
bemoaning
big
bank
profits,
now
the
calls
are
to
break
up
banks
to
unlock
value
for
investors
the
1%!
Thats
some
transformation!
The
theory
goes
that
large
banks
are
somehow
holding
back
smaller,
but
more
valuable
businesses
and
that
government
caps
on
bank
size
will
help
to
unleash
profits
in
these
firms.
Investors
should
therefore
join
with
regulators
in
calling
for
breaking
up
the
big
banks.
The
otherwise
brilliant
Sebastian
Mallaby
argued
this
case
in
his
recent
Financial
Times
column
[Breaking
Up
Banks
Will
Win
Investor
Approval],
arguing
that
the
combination
of
big
banks
funding
advantages
in
the
debt
market
and
funding
disadvantages
in
the
equity
market
suggest
that
the
capital
adequacy
police
should
capitulate
to
(presumed)
investors
sentiment
and
just
break
up
the
banks.
Now,
lets
set
aside
the
reality
that
advocating
a
policy
with
the
express
rationale
of
elevating
profits
for
bank
investors
would,
on
its
own,
drop
jaws.
Anythings
game
if
wrapped
in
populist
bank
bust-up
goals.
Lets
instead
analyze
the
fundamental
assertions.
Investors
market
participants
are
neither
monolithic
nor
prescriptive
in
policy.
Decisions
are
made
in
the
aggregate,
reflected
in
equity
(and
debt)
pricing.
If
investors
are
skeptical
of
large
banks,
and
the
capital
adequacy
police
maintain
their
hold
for
clear
capital
requirements,
then
the
market
will
reduce
the
size
and
makeup
of
banks
if
warranted
without
the
heavy
hand
of
government.
This
pricing
and
scaling
process,
by
the
way,
plays
out
in
all
industries.
In
some
circumstances,
investors
want
larger,
diversified
companies,
while
in
others,
the
market
wants
smaller,
more
narrowly
focused
pure-plays.
In
a
competitive
market,
theres
room
for
all
kinds,
with
varying
degrees
of
predictability,
cyclicality,
risk
and
price
premia.
The
short-term
burst
of
spinning
off
the
most
profitable
parts
of
a
business
(as
Mallaby
implies)
does
not
always
make
the
best
long-term
strategy.
The
market
has
the
mechanisms
to
decide.
Bond
market
advantage?
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Advocates
for
breaking
up
the
banks
often
cite
that
big
banks
can
more
cheaply
finance
themselves
in
bond
markets
than
small
banks.
Specifically,
Mallaby
offers
two
reasons:
First,
U.S.
tax
policy
subsidizes
debt
issuance
relative
to
equity.
Second,
market
participants
believe
banks
will
be
bailed
out
and
that
therefore,
bondholders
feel
safe,
requiring
less
of
a
return
for
their
investment.
The
first
point
is
entirely
valid.
Government
policy
does
in
fact
subsidize
debt
over
equity
for
banks
as
well
as
for
every
other
company
in
the
country.
Its
a
tax
distortion
that
should
be
fixed,
but
its
not
a
unique
benefit
to
banks.
The
second
point
may
be
valid
as
well,
but
theres
absolutely
no
basis
for
such
a
belief.
Unlike
the
actions
taken
during
the
financial
crisis
when
bondholders
were
bailed
out
(however
necessary
at
the
time),
the
new
Resolution
Authority
makes
it
clear
that
bondholders
and
other
creditors
will
take
losses
if
a
firm
fails.
Recent
ratings
downgrades
on
the
big
banks
from
the
major
credit
ratings
agencies
have
underscored
this
market
reality.
In
the
absence
of
a
clear
bond
market
advantage,
lets
move
on
to
equity,
which
has
become
more
expensive
for
big
banks.
Equity
valuations
There
are
many
variables
affecting
the
profitability
of
banks
and
bank
share
prices,
and
these
variables
make
pricing
bank
stocks
difficult
in
the
short-term.
Big
banks
face
a
slew
of
regulatory
challenges
and
changes
impacting
profitability
the
hundreds
of
Dodd-Frank
reforms
including
the
Volcker
Rule
prohibitions,
Durbin
Amendment
interchange
fee
price
fixing,
new
FDIC
insurance
premiums
for
non-deposit
liabilities,
and
significantly
higher
capital
requirements
for
systemically
important
financial
institutions
are
but
a
few
examples.
In
recent
years
a
significant
amount
of
bank
capital
has
also
been
tied
up
in
provisioning
for
housing
related
losses.
Bank
valuations
may
also
be
depressed
due
to
the
dilution
of
shareholders
as
banks
raise
Tier-1
equity
and,
in
some
cases,
have
been
blocked
by
governments
from
buying
shares
back
or
paying
dividends.
Government
policy
seeking
to
minimize
trading
and
new
counterparty
risk
regulations
are
probably
impacting
profitability
as
well.
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All of these variables are real and observable, impacting top and bottom lines of the bank business, while the bank break-up value theory rests instead on ephemeral moral hazard pricing. Mallaby rightly argues that equity investors are wary of being wiped out in the event of a bank failure. After all, Dodd-Frank Resolution Authority gives the FDIC the tools to wind down a large institution, wipe out its creditors, sell assets, and, if there is enough money left over after Treasury is repaid, to trickle down to bondholders. In Mallabys presentation, the regulators selective concern with moral hazard is driving up the cost of equity. But theres nothing selective about it. What Mallaby describes is the basic capital structure of any publicly traded company and normal resolution through bankruptcy. In bankruptcy, bondholders are senior to equity shareholders. Shareholders benefit from upside risk, but sit in a first-loss position if a firm fails. This is no different than in any bankruptcy: shareholders are in the exact position of, say Starbucks shareholders in the event of a bankruptcy. Market-determined bank size More to the point with these investor value theories, the market has all the tools it needs to reduce bank size if warranted. Even if it were appropriate, the market hardly needs government to help investors. Market participants are free to take their investments to smaller banks. Meanwhile, regulatory requirements under Basel III require big banks to raise equity to buffer against potential future losses. This leaves banks with two choices: face higher costs for equity, or reduce assets get smaller. This is the market working. The outcome Mallaby seeks doesnt require the heavy hand of government, just the enforcement of capital requirements. Currently, Americas four biggest banks have raised their common equity to assets (not risk- weighted, no games) ratio significantly since the crisis (Exhibit 1).
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Exhibit!1 !
HPSinsight.com
ON AVERAGE, THE 4 LARGEST U.S. BANKS HAVE INCREASED THEIR EQUITY RATIO TO ALL-TIME HIGHS!
Common Equity And Common Equity/Assets For Top 4 Largest BHCs! 10! Comon Equity/Assets (%)! Common Equity ($)! 180! 160! 140! 8! 120! 100! 80! 6! 60! 40!
9!
7!
5!
2003Q1!
2004Q1!
2005Q1!
2006Q1!
2007Q1!
2008Q1!
2009Q1!
2010Q1!
2011Q1!
Source: SNL, 4 banks are JP Morgan, Citi, Bank of America, Wells Fargo!
Indeed,
from
the
strategic
point
of
view
of
management,
there
are
compelling
arguments
to
being
large,
global
and
diversified
in
some
cases,
and
compelling
arguments
to
being
small,
local
and
more
narrowly
focused
in
others.
In
the
long- term,
business
diversification
spreads
risk,
lowers
volatility
and
lowers
the
effects
of
cyclicality.
There
also
exist
economies
of
scale
that
size
and
diversification
can
generate.
To
maximize
shareholder
value,
some
banks
may
decide
to
get
smaller,
while
others
may
view
the
economies
of
scale
and
diversification
of
a
global
universal
bank
as
vital
to
their
success
and
responsive
to
their
customers.
Either
way,
investors
are
free
to
choose.
But
theres
no
useful
principle
where
government
should
favor
short-term
profits
for
some
equity
investors
while
ignoring
the
needs
of
individuals
and
companies
who
rely
on
big
banks
scale,
reach
and
expertise
to
operate
in
rapidly
growing
global
markets.
Banks
can
compete
and
serve
customers
at
the
global
level
while
maintaining
adequate
capital,
liquidity
and
transparency.
And
leave
bank
size
to
the
market
and
the
needs
of
customers.
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2012Q1!