U.S. Financial System Still Needs at Least $1.0 Trillion to $1.2 Trillion
Summary and Recommendation
The U.S. financial system needs at least $1.0 trillion to $1.2 trillion of tangible common equity to restore confidence and improve
liquidity in the credit markets. The private sector lacks the necessary confidence and financial flexibility to meet the capital shortfall.
Investors have been unable to price risk in equity markets due to high-profile banking failures, coupled with difficulties quantifying
opaque credit default swap (CDS) market exposure. The U.S. government must supply the interim funding to weather the crises; later,
once the system is running smoothly and private capital begins to return, we can debate the best way for the government to extract itself.
Ultimately, once appropriate capital levels are established and asset pricing is rationalized, private market participants will reenter the
financial system.
Key Points
• State of the financial system today.
Currently, the U.S. financial system has $37 trillion of debt outstanding. While we consider
the bulk of this amount adequately capitalized, we identify eight large financial institutions that we consider in greatest need of
capital as they have relied heavily on non-deposit funding. Combined, these eight financial companies have roughly $12.2 trillion
of assets and only $406 billion of tangible common capital, or just 3.4%. Given their dependence on short-term funding and the
illiquid nature of their asset bases, our analysis indicates that these institutions need somewhere between $1.0 trillion and $1.2
trillion of capital to put their balance sheets back on solid ground and begin to extend credit again.
• How did we get here? Simply, as a society, we did not demand enough capital in the financial system given the risk on the balance
sheets. Recent practices have only exacerbated the problem. In the credit crisis of the 1930s, regulated depositories held most
financial debt (63% in 1945, our earliest data point), and their liability structure was 98% deposits. Over time, advances in
technology and regulatory disintermediation pushed financial assets outside the regulated banking system, resulting in higher
leverage and greater reliance on short-term debt instruments. By 2008, only $11 trillion of assets (30% of total) were loosely
regulated in the banking system, while more than $26 trillion were outside the banking system, some in other regulated industries,
but some with very little regulatory oversight with respect to both capital and underwriting standards. Financial innovation just got
too far ahead of itself. Today, the government is pulling these financial assets under regulatory watch through the issuance of
commercial banking charters (i.e., GS, MS, AXP, CIT, etc.). This will help going forward, but it does not solve the immediate
capital shortfall problems.
• Debt or TARP capital is not true capital. Long-term debt financing is not the solution.
Only injections of true tangible common
equity will solve the current crisis. Tangible common equity is the first loss position and will absorb the majority of balance sheet
deficiencies. If losses are large enough to affect book value and stock price significantly, a company's probability of failure
increases, regardless of the level of preferred or regulatory capital.
• The government will have to lead the recapitalization. Initially, the bulk of $1.0 trillion to $1.2 trillion of capital will have to
come from the government. The sheer size of the capital deficiency, coupled with the opaque nature of credit risk, will keep private
capital sidelined. Eventually, capital levels will be strengthened by both private capital raises and internal capital generation, but the
federal government will have to be the primary first responder to the crisis. If the government would convert TARP capital
issuances into pure, tangible common capital (akin to the $23 billion C class investment in AIG), it would go a long way toward
encouraging subsequent private investment. A bank holiday on dividend payments is another appropriate step toward preserving
capital. Political will is building for these types of solutions. The quicker the government acts, the sooner the financial system can
work through its current problems and begin to supply credit again to the economy.
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