Capital vs. liquidity: Why the debate comes up short

The latest debate over capital levels highlights an age-old storyline, pitting the importance of capital against that of liquidity in bank evaluations.

The traditional approach to bank regulation has been the CAMEL view, where the emphasis in monitoring banks, in order of priority, has been capital adequacy, asset quality, management capability, earnings and liquidity. (The traditional CAMEL acronym was later expanded after several financial crises to CAMELS to reflect the importance of sensitivity to interest rate risk.)

The regulatory focus on bank capital began in the late 1800s with informal capital-to-deposit guidelines. They became formalized with specific capital-to-asset requirements after the Great Depression. And whenever there is an actual or perceived problem at a bank, the regulators have historically required more capital.

The directly opposite approach, traditionally promulgated by the industry, has been the so-called “LEMAC” view, where bankers believe liquidity and earnings are most important with asset quality and capital being of lesser importance. Bankers argue, among other things, that higher capital reduces their capacity to lend and get an acceptable return on capital.

Citibank promoted the LEMAC approach in the 1980s when they were under regulatory pressure to increase relatively low capital levels in the face of Latin American debt problems.

Citibank’s view then — and the view of many bankers today — is that liquidity management is of paramount importance. As long as a bank has access to funds, even at an increasing cost, it can stay in business until the market refuses to provide liquidity at any cost or the regulators shut the bank down. As long as a bank continues to make money, as they are doing today, shareholders are happy, bank management is happy (and compensated for those gains) and regulators should be happy, as this should mean more capital.

This LEMAC view is supported by many past examples of failures of large banks (e.g., Wachovia and Washington Mutual) and financial companies (e.g., Lehman Brothers) — these banks had adequate capital, but were unable to generate liquidity at any cost because the market lost confidence in them.

What makes today’s debate over capital different is that it is pitting several former regulators who favor a capital-based approach against new ones who back the liquidity-first view. This is not surprising, however, since much of the new regulatory guard, including Treasury Secretary Steven Mnuchin, is made up of former bankers.

But the problem with simply distinguishing between CAMEL and LEMAC views is that the component factors are interrelated. For example, thinly capitalized banks with serious asset quality problems in the recent financial crisis also faced liquidity issues and ultimately failed.

The ongoing debate also downplays what is perhaps the most important component: the middle “management” factor. While capital, asset quality, earnings and liquidity can be measured and regulated, this is not the case with management concerns.

Experienced and knowledgeable management and directors with a good reputation and the “right” culture in their bank not only have the support of their regulators but also their customers and shareholders. This is critical when there is a need for more liquidity or capital. The best of these high-performing banks not only excel in traditional safety and soundness ratings, but also in their compliance ratings.

Bank regulators and other enforcement agencies do everything they can to encourage good management and director behavior and discourage bad behavior, but it never seems to be enough — or to get done in a timely fashion, as we saw with the Wells Fargo scandal. Based on the regulatory failures at Wells Fargo, it appears that the agencies themselves should improve their own management skills.

I am hopeful that our new slate of bank regulators will not only be mindful of both the CAMEL and LEMAC views, but also put needed emphasis on the critical management factor.

A good start, which I recommended nearly 20 years ago, would be to make public the CAMELS ratings, especially the management component, to both encourage additional market discipline and to hold management and boards more accountable. This was successfully done in the compliance arena with Community Reinvestment Act ratings in 1990, and it is time to consider this proposal on the safety and soundness side.