Why injecting Bank Capital is way more effective than buying toxic assets

This is a point not grasped by everyone. Not a reporter at Bloomberg, and even more surprisingly, not by Paul Kedrosky, who otherwise runs an excellent blog.

We have touted the Gordon Brown plan which differs from the original Paulson plan in that it focuses on recapitalization of banks, rather than buying toxic assets. This difference is a little tricky and some failed to grasp it entirely. Yet, it is very important.

Kedrosky took the story from Bloomberg. The argument is that the new capital injections from the private sector and through government bailouts are only just making up for the losses in sub-prime mortgages, and, more ominously, other bad credit as a result of the recession will easily tip the banks into insolvency again.

In the Kedrosky variant:

  • The following more or less supports what some have been saying for a while -– that major banks in the U.S. and the U.K. will end up being entirely nationalized before this crisis is over –- but it’s still a striking way of looking at the data. The gist: Government recapitalization and other fund-raising has largely been in service of banks’ prior subprime losses, while corporate and consumer loans are just starting to hit bank balance sheets. It won’t take much to tip banks over into insolvency again.

This would be true if the bailout plans were of the original Paulson variety, just buying dud assets. Instead, Gordon Brown crucially intervened with his UK plan, buying stakes in the banks themselves, that is, injecting capital.

Buying dud assets just makes up for the losses in solvency on a one-for-one ratio, however, injecting capital is much more effective, improving solvency at a ratio of over 10:1.

The capital requirement depends on the mix of assets, these are weighted depending on their (perceived) riskiness:

  • Cash and cash equivalents and Government securities have a weighting of 0
  • Interbank loans have a weighting of 0.2
  • Mortgage loans have a weighting of 0.5
  • Ordinary loans have a weighting of 1.0, as have Standby letters of credit

The Bank of International Settlements (BIS) sets requirement for capital that many countries adhere to, and make a distinction between two types of capital:

  • Tier 1 capital is the book value of its stock plus retained earnings.
  • Tier 2 capital is loan-loss reserves plus subordinated debt (long term debt that, in case of insolvency, is paid off only after depositors and other creditors have been paid.  Thus it can be used like equity to provide those creditors some protection against insolvency.)
  • Total capital is the sum of Tier 1 and Tier 2 capital.

The BIS requirements are:

  • Tier 1 capital must be at least 4% of total risk-weighted assets.
  • Total capital must be at least 8% of total risk-weighted assets.

Let’s assume a bank has the following asset mix:

  • Cash and equivalents: $40m
  • Government securities $80m
  • Interbank loans $100m
  • Mortgage loans $200m
  • Ordinary loans $300m
  • Standby letters of credit $80m

The total risk-weighted assets is 0 x $40m + 0 x $80m + 0.2 x $100m + 0.5 x $200m + 1.0 x $300m + 1.0 x $80m = $500m.
The bank must have Tier 1 capital of at least .04 x $500m = $20m and Total capital of at least .08 x $500m = $40m.

It can be showed that injecting capital is way more effective compared to buying assets.

Say the Bank had $40m in total capital and $500 in assets, just complying with the 8% capital ratio requirement. Say the government would have bought $100m of the most risky assets, what would have happened?

  • Since the most risky assets have a weighting of 1.0, total assets decline by the full amount, $100m.
  • On the other hand, cash has been increased by $100m, but since that has a weighting of 0, it doesn’t influence total assets.
  • So total assets decline by $100m, improving the asset/capital ratio to 10%
  • The bank could buy new assets, depending on their risk profile. We already know that with $40m in capital, they could have $500m in weighted assets, they only have $400 in weighted assets, so they can issue $100m in ordinary loans or standby letters of credit, $200 in mortgage loans (since these only have a weighting of 0.5), or $500 in interbank loans (weighting of 0.2), or any weighted combination of these

Now, if the government had put $100m in capital instead of buying the most risky assets, total capital would have been $140m and the asset/capital ratio would have been much higher at 35.7%. $140m in capital would support 12.5 times as much weighted assets, to assets can grow to a whopping $1708m, while they only have $500 in assets.

The bank could lend out (ordinary loans) the entire difference of $1208m. Since mortgage loans only have half the weighting, they could even engage in double that amount ($2416m) in new mortgages.

See the difference?

Some, like Paul Kedrosky, don’t.

There was a reason why that Gordon Brown plan was much more effective, one of these we’ve just explained. Pumping new capital into banks is much more effective compared to buying dud assets from them. And the bank stakes the Government acquires also provides other advantages,

  • like having people on the board of banks who can stop excessive salaries and bonuses
  • or the stakes can be sold off at a huge profit when the economy has recovered.