The Language of Bank Capital Management

An interesting post about finance semantics from John Cochrane (short and easy to read):

In this post, he takes aim at some language used in the current legislative proposal to replace Dodd-Frank. The irony is that the language he criticizes is in fact quite standard in banking. And more than being standard, it is meaningful in the context of how bank capital is deployed for its core purpose – risk taking. The essential purpose of bank capital is to absorb losses when they occur. It is an additional characteristic of bank capital that it acts as a source of funds that does not have to be repaid – an essential liquidity attribute.

My comments under Cochrane’s post:

Yes, capital is a form of funding. And it is not “held” in the sense that it is not held as an asset. The terminology is not exactly pristine.

However, the question of “how much capital to hold” is indeed very common terminology in the industry. That’s not the best excuse, but I suppose one might make more sense of it in the abstract (but balanced) context of “holding” both assets and liabilities (and equity) as balance sheet items.

(This can all be quite confusing for those trying to learn how banking works, similar to the case of the various contexts for the use of the term “reserves” (reserves held in the asset of “high powered money”; loan loss reserves “held” as liabilities; etc.))

Where I disagree in a more substantive way:

If $ 236 billion is the correct number, then that number is required as equity funding and is allocated to support operational risk. If some regulator were to deem this capital support is no longer required, and if bank management agreed with that, then the bank no longer needs that amount of equity funding (other things equal). The salient point here is that equity funding is the most expensive form of funding – the highest cost of capital in the much broader sense of that word capital (i.e. all funding forms). So equity funding can be replaced with cheaper funding. The point is not that the stock price goes down after a dividend is paid – it is that the bank is now more highly leveraged (as permitted) to allow for higher margins in respect of the future return on capital. Similarly, even though the book and market values of total equity will decline after a stock buyback, the bank will be in a higher leveraged position for future increased return on capital, other things equal. “Windfall” is probably a poor use of that word, but in fact the expected ROE or at least the expected earnings per share will be higher after such dividends or buybacks, other things equal, and it is because operational risk capital has been jettisoned from its prior use in this example.

And it is absolutely correct that such freed up capital could be “used for more lending” in this context. Although capital is a source of funding on a 1:1 basis, it is also a source of risk support, which in the case of credit risk might be something more like 10:1 (or whatever) for loan assets supported by a given quantity of capital in the context of risk, along with other forms of funding. Capital is a source of nominal funding, but it is also a source of potential balance sheet expansion beyond that nominal funding source. It is in the associated leveraged expansion of assets that “used for more lending” is perfectly appropriate. It’s just that more lending can’t occur without the support of additional non-capital funding in order to fully fund the nominal asset expansion.

In a similar vein, “tied up capital” is also very common industry parlance. And it’s not so bad. The idea is that capital must be allocated to various risks, and the quantity of capital is limited. Whether operational risk, credit risk, market risk, whatever risk … it is the allocation of capital to these various business risks that “ties it up” once that allocation has been made. If that capital can be freed from that business requirement, then it can be used to support other risks, or paid away in share buybacks or special dividends.

I think it helps to frame language use in capital management by considering the internal organization of banks in the management of liquidity and capital. These essential banking functions use language that is sometimes distinct and sometimes intersecting.

The language you are implicitly comfortable with through this post is the language of liquidity management. That is the function that is arguably the most visible to outside interpreters of banking – including professional economists. Although I assure you it is very complex when viewed from the perspective of internal organization. Capital as you say is a source of funds. This is associated with the commonly understood perspective of basic flow of funds accounting, which reflects at the core the function of liquidity management. And this is quite visible to the outside world through a simple categorization of funding types in conventional financial accounting statements such as balance sheet and sources/uses of funds. I think the potential abuses of language that you cite are in the context that they don’t make much sense when viewed from that perspective of funds flow and liquidity management.

What is less visible to the outside world is the nature of the internal accounting systems that are used by banking in the allocation of capital to risk. That is the essential role of capital, making it different from other sources of funding. These capital allocation systems intersect with flow of funds accounting in interesting ways.

One of the ingredients of such an internal capital allocation system is the identification of excess capital. This is a clear delineation of capital that is on the balance sheet but that has not yet been allocated in the sense of its use in backing risk and acting as insurance against losses from existing businesses. The presence of excess capital is linked through internal funds transfer systems to specific risk free (or close to risk free), liquid assets such as treasury bills for example (albeit even there with very minor interest risk perhaps). The loss insurance purpose is not a requirement for those assets, so the connection is consistent with the notion of capital excess. The rest of the capital – that which is not excess (which is obviously most of it in the normal case) – is allocated to risk taking businesses. This includes capital for credit risk, market risk, operational risk, etc. etc. Those allocations to specific risk areas include a similar type of liquidity connection as is the case for excess capital, where the loss insurance function exists jointly with the funding function.

I think the use of the word “holding” for starters becomes a little more understandable if one thinks of the allocated capital as being compartmentalized into specific risk support categories – for different businesses and for different types of risk. That capital is “held” for those uses in the sense of not being available as excess capital and therefore not being available for new purposes. It is being used and therefore can’t be released or allocated to new purposes. Maybe think of it as a realized “hold back” of the large proportion of total existing capital, not available for other purposes, compared to a portion of total capital that is currently excess and more freely available either to be used for new business risk taking or to be distributed to shareholders.

Perhaps that makes the language of “held”, “used”, and “tied up” a bit more understandable. This is the language that is commonly used in the context of capital allocation systems, where capital is considered for its essential purpose as protection against losses, that being the critical refinement on its more basic characteristic as a source of funding – a source of funding that is good only so long as those losses are not being experienced.

“No bank “holds” capital, and I hope Mr. Dimon didn’t actually say that, as much as he would like lower capital requirements. Capital is not “held” like reserves.”

I assure you that he uses this kind of language frequently – in the context of all of the risks that capital supports. And I further assure you that he knows the difference between the asset and liability sides of the balance sheet. And I am quite certain that he knows that capital does not reside on the asset side of the balance sheet.


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