Financial Bandwidth – You're gonna need a bigger pipeline.
Tom Friedman has been quoting Roy Scheider's character in Jaws on first seeing the great white shark: “You're gonna need a bigger boat.” Friedman is talking about the size of the financial bail-out, the amount of money the Government is going to have to throw at the problems of our banks and other financial institutions to get them running again. I'm not sure I agree with Friedman on that claim, but I do know that if we restrict the leverage that those institutions can carry, we're going to need a lot more capital, and I don't know where that will come from.
Sec. Geithner says that the key to avoiding future meltdowns is “capital, capital, capital.” The Secretary's position bespeaks a sound, minimalist approach to regulation. The idea is that if financial institutions have a sufficient capital base, not only will they have a cushion with which to cover losses, but also, because they have so much capital at risk, they will take less risk with the money. As I said, this is sound thinking.
The problem with the Secretary's position is that excess leverage does not arise in a vacuum. Excess leverage arises when there is more cash to move than capital available to guaranty it. Think of Wall Street as a pipeline through which import dollars flow back into the American economy. An actual oil pipeline has to be big enough and strong enough to reliably carry oil from the well to the seaport. But size and strength are competing requirements: the thicker the walls of the pipe, the less its inner diameter and the less oil it can carry. Yes, the pipeline can be strengthened by adding thickness to the outside, but only if there is room in the system for a wider pipe. In many cases, it would appear to be easier to line the inside of the pipe without changing the shape of the pipeline than to accommodate an increased gross diameter. At least one can imagine how that might be the case.
The same principles apply to the financial “pipeline” that returns dollars to the US. If the economy returns to the level of pre-crash activity, the amount of petro- and sino-dollars that need to be recycled here will return to the volume that was being processed by our 30-1 pre-crash system, and those dollars will have to flow through the same pre-crash pipeline, because that's all there is right now. But the pipe will have been narrowed by increased capital requirements.
A bank that leverages at 30-to-1 can repatriate $300B if it has $10B in capital. A bank that leverages at 12-to-1 can accommodate only $120B. So where does the other $180B go? How does it get into the country? Some of it will doubtless become bank capital, probably against the better judgment of its owners. If putting $1B at risk enables a sovereign wealth fund to invest $11B with much less risk, and at a return greater than Treasuries even with the capital haircut, that's probably a risk worth taking. Sheik Alwaleed Bin Talal already owns a ton of Citibank, so he's already providing some capital for his country's' reinvestment. But that's at pre-crash levels. Maybe he'll need to buy more. And maybe he'll have to provide capital to other banks.
But is this what we want? Our banks being bought up by foreign investors, not because they think the banks are such good investments but because that's the only way they can get bonds to buy. Under that scenario, one would expect our trading partners to by-pass the investment banks entirely, setting up their own direct investment offices and not being bothered by capital requirements. Then who will need the banks?
The question that remains to be answered by events is whether a 12-1 banking system, strong as it may be, will have the capacity to service enough of the money coming home. Or will its role be supplanted by entities created for that purpose by trading partners who find our banks too puny for their needs.