Volume 1
Banking: The Prisoner’s Dilemma

The results of the annual banking stress tests were published on the 23rd of June 2016, and there were many victims. The US Federal Reserve tested 33 institutions and three were found wanting. Two failed outright, and one was given notice. These tests are based on hypothetical shocks that include negative interest rates, stock price declines, high unemployment and GDP erosion. The results are aggregated and the impact on capital and liquidity is assessed by the Fed. When a bank fails, that bank in theory should already be cognisant of its insouciance, since the thresholds are well understood.

Since the 2007 Financial Crisis, a plethora of new regulations were introduced by all countries falling within the aegis of the Basel Committee for Banking Supervision (BCBS). Because all banks necessarily trade cross-border and because the BCBS falls under the Bank for International Settlements, the BIS, which governs interbank cross-border settlement, banks, and in turn their governments, tend to comply. Those banks which fail, in spite of their status as non-governmental exchange-traded entities, are restricted from issuing dividends and paying shareholders as they please. Deutsche Bank, one of the two banks that failed the US tests, cannot be paid a dividend by its US subsidiary, at least not until its subsidiary has modified its balance sheet to the extent that it can pass the stress tests.

To be fair, all of this seems quite reasonable given the extent to which the Financial Crisis impacted US taxpayers, as well as taxpayers in many other countries. But the regulations go somewhat further than insisting on annual stress tests. The capital requirement itself has also been dramatically increased. Under Basel II regulations, ratified in 2006, the total common equity portion of the capital requirement of risk- weighted assets was 2 percent. Risk-weighted assets is the concept the BCBS invented to mean the weighting of the balance sheet of a bank based on perceived riskiness. This equity capital requirement is now 4.5 percent under Basel III rules and can go as high as 7 percent. That is between a doubling and a tripling of the shareholders’ portion of the capital buffer. This goes a long way to explaining the very bearish price earnings multiples we have seen in global banks over the past nine years.

Even more onerous, however, are further provisions within the stress testing rules. Recall that two banks failed and one was given notice, Morgan Stanley. Being given notice by the Fed is akin to being sent to the principal’s office, whilst failing is akin to being suspended. Morgan Stanley passed the stress test itself, yet failed to demonstrate that their systems and processes are sufficiently robust. What is implied here, but never explicitly stated, is that Morgan Stanley may have fudged its results. Their systems are too messy to tell – at least that is the accusation. Fix them or else.

Let us consider this from the perspective of Morgan Stanley shareholders. Surely, they might argue, these provisions limit shareholder payout and impinge on their rights. This is a very warped version of free-market capitalism, they cry. The managers of the bank, recall, are unable to prove that they haven’t cheated the tests – tests based on hypothetical scenarios made up by quantitative analysts who work within a global bureaucracy based in Switzerland. My hypothetical investor is a US citizen based in Kentucky, or a pension fund based in California. The Fed now reserves the right to withhold the payment of dividends should the managers not manage to prove their innocence.

At the height of the 2007 Financial Crisis there were commentators who predicted the failure of the entire financial system. A complete overhaul was needed. There was a very clear option available to the lawmakers in 2008. They could simply reinstate the Glass-Steagall Act of 1933. This law was very simple. It said that you can’t be an investment bank and a deposit-taking institution at the same time. In this world, the pensioner from California could not be held liable for the risks taken by a proprietary trader in Manhattan. This was how Morgan Stanley was created in the first place. It was the investment banking spin-off when JP Morgan was split into a deposit-taking bank and an investment bank. Bill Clinton, under pressure from Wall Street, abandoned the principles of Glass-Steagall and eight years later the Financial Crisis hit. One wonders whether the outcome now is better than it would have been if Glass- Steagall had simply been recalled. In the new world order, under the weight of thousands of pages of new banking legislation, banks are micro- managed by regulators, hypothetical tests can alter one’s shareholder return, and multiples more than was previously spent on compliance is now required to even hope to meet regulatory requirements.

It would take an ingenious argument to demonstrate that free-market capitalism exists in the banking industry today. Had the punishment just been taken once and for all in 2008, that shareholder in Kentucky might just be getting his dividend today.