Too Big to Regulate? The Warren Debut
Elizabeth Warren’s questioning of financial regulators at her first Senate Banking Committee hearing got a lot of attention for her pointed question about when was the last time any of their agencies had taken a large bank to trial. It was a telling exchange, but I think the attention it received overshadowed her even more interesting second question (here at 04:29): why is the market capitalization of the major banks lower than their book value?
Typically companies' market cap is above their book value, but for many large banks, it has been below since 2008. JPMorgan Chase, however, has a book value of $195 billion, but a market cap of just $186 billion. (Market:Book of 95%) And Bank of America has a book value is $218 billion, but the market cap is only $129 billion. (Market:Book is just 59%.) What accounts for the staggering $89 billion gap? To put things in perspective, a bank with $89 billion in assets would be the sixth largest in the US, just behind Goldman Sachs, and just ahead of MetLife and Morgan Stanley.
Senator Warren proposed two possible (and possibly consistent) answers: that investors think the banks have inflated books or that they're too big to manage.
(2) Too Big to Manage. The other possibility, Warren suggested, is that there could be a management discount for the banks. The large banks are just unmanageable, so investors are discounting the book value of the assets to reflect the negative management synergies created by large banks. This would imply that for the health of the US banking system, the big banks need to get broken up. It would also raise the question of why shareholders haven't pushed for the banks' breakup.
When asked to comment, only Federal Reserve Governor Daniel Tarullo responded. (There was something fantastic about one former law professor grilling another about bank regulation in a Senate hearing.) Notably, Tarullo did not disagree with Warren, nor did he say anything about the possibility of inflated books. The nonresponsiveness on that point was telling. Instead, Tarullo suggested a third possible explanation for the maket-book gap: investor skepticism that the banks would produce sufficient returns on equity.
Tarullo explained that a sufficient return on equity would be something above the return produced by the individual parts of the bank. I don't completely understand what he meant, but I take it as a statement that investors are skeptical that there is any going concern value in the banks. He then went on to tie this to uncertainty--very carefully stating that this is what bank analysts would say, rather than what he would say--about the regulatory environment and the "franchise value" of the institutions and "the environment of economic uncertainty."
Theoretically, Tarullo is certainly right that market cap might be depressed for the large banks because of regulatory uncertainty. Depending on how big banks are regulated, they may become less attractive investment opportunities. That said, I have trouble believing that this explains all or even most of the market-book gap. First, it would indicate that the market believes there is a considerable chance that the Fed and/or Congress will engage in meaningful regulation of too-big-to-fail. Nobody (query if that includes Governor Tarullo) believes that is likely to happen. To the contrary, there may still be a too-big-to-fail premium, which would be narrowing the maket-book gap. Second, it's not clear why regulatory uncertainty would produce such different market:book ratios for BofA and JPM. (The fact that the market-book gap has shrunk since 2008 might also suggest that the market thinks the likelihood of ending too-big-to-fail is declining.)
The "franchise value" part of the answer confused me, perhaps because of terminology. I think Tarullo was essentially stating to the too-big-to-manage point, but framing it differently, in that there aren't synergies from being big and diversified operationally.
As far as "economic uncertainty"-it's hard to know exactly what Tarullo meant, but given that the Fed has told us that rates are going to basically be zero for the next couple of years, one wonders how much uncertainty there really is beyond what always exists. Perhaps this was in reference to continued manufactured federal debt and budget crises.
Senator Warren's second question was one of the most probing inquires put to banking regulators in the past five years. Basically, they were being asked whether they were coddling too-big-to-fail banks by letting them pretend to be solvent or stronger than they are. In other words, she was asking whether the Emperor has no clothes. The question was technical enough that the media didn't pick up on just what an awkward inquiry is was, but I think it deserves some attention.
When combined with the question about lack of prosecution, the market-book question points to a deeper underlying concern: that prudential bank regulators are unwilling to undertake regulatory actions that in any way rile the financial system. Whether this would be because of regulatory capture or a fear of triggering another financial crisis is not clear to me, but it speaks to a fundamentally unregulatable industry, at least as currently structured.