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Did John H. Cochrane, a professor of economics at Chicago, wrote:

In order to make $100 of loans, a typical bank borrows $97—from depositors, from money-market funds, from other banks, or from bondholders—and sells $3 of stock, its "capital." So if only 4% of the bank's loans fail, the shareholders are wiped out, and the bank cannot pay its debts. Worse, if there is a rumor that some loans are in trouble, creditors may "run," each trying to get his money out first, and force a needless bankruptcy. Think of Jimmy Stewart in "It's a Wonderful Life."

Putanumonit claims on his blog that the 3% is wrong:

As Cochrane was writing those words, in March 2013, the average equity ratio of US banks was 11.2%, up from 6% in the late 1980s.

[...]

Let me repeat that: economics professors who wrote a book about how raising equity ratios will solve the problem of financial crises got the actual equity ratio for banks, a number that is publicly reported and easily googlable, wrong by a factor of 4.

Does Putanumonit charge have merits or is there an apples-to-oranges comparison?

  • The blog posts does explain that the difference is the number is risk-weighted, which would explain these different numbers. – Mad Scientist Dec 18 '18 at 17:39
  • Unless "equity ratio" is something different from reserve ratio, the amount of money a bank must keep from each deposit is a regulated number. 10% I think. Banks can only loan out up to $90 of every $100 in deposits. – fredsbend Dec 18 '18 at 17:42
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    @fredsbend the relevant regulations are Basel II (or maybe Basel III now), but those are incredibly complicated. And a large part of that is more individual weighting and rating of risks. – Mad Scientist Dec 18 '18 at 17:44
  • @MadScientist as per kh's comments on Cochrane's blog, the risk-weighting works in the opposite direction, and does not explain these different numbers. So Wells Fargo has an equity ratio of 11% on an unweighted basis, and a much higher number on a weighted basis. – EnergyNumbers Dec 18 '18 at 18:04
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    @fredsbend you're comparing assets and liabilities. This question is about comparing equity and assets. – EnergyNumbers Dec 18 '18 at 18:16
3

John Cochrane did not source his material well. I suspected the numbers supplied by Putanumonit were sourced from capital stress testing that the Fed performs, and I was right. {I could not find the quarterly results which surely would have the number exactly}. It's from the Comprehensive Capital Analysis and Review 2014: Assessment Framework and Results.

As shown in figure A, the aggregate tier 1 common equity ratio of the 30 BHCs (ed. note from KDOG: Bank Holding Companies) in the 2014 CCAR (ed. note from KDOG: Comprehensive Capitals Analysis and Review, aka stress testing) has more than doubled from 5.5 percent in the first quarter of 2009 to 11.6 percent in the fourth quarter of 2013.1

That gain reflects a total increase of more than $511 billion in tier 1 common equity from the beginning of 2009 among these BHCs to $971 billion in the fourth quarter of 2013.

Please note the almost perfectly aligned numbers which can be attributed to timing differences.

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    The John Cochrane quote is from his Wall Street journal review of Anat Admati and Martin Hellwig's book. He trying to explain what that book says, in a limited amount of space. – DavePhD Dec 30 '18 at 19:18
  • @DavePhD: Interesting... So in fact Putanumonit should not be attacking Chochrane's 3% example, but should be attacking what is in the book ("economics professors who wrote a book"). – GEdgar Dec 31 '18 at 14:31
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No.

Taking Bank of America for example, according to the Bank of America Corporation 2017 annual financial report (see especially Table 6 on page 39):

The value of all loans and leases was $937 billion while the value of deposits was $1,310 billion.

More broadly, the value of all assets (loans and leases being assets), after allowing for a $10 billion loss on loans, was $2,281 billion.

Liabilities, (deposits being considered liabilities) were $2,014 billion.

Shareholder equity was $267 billion.

So the ratio of equity to loans and leases was 267 / 937 = 28%

The ratio of equity to total assets was 267 / 2281 = 12%.

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