Most of what we call money is actually short-term debt created by banks when they make loans.This means that banks are the stewards of our savings and manage the payments system.
As a result, they have a privileged place in our society: governments never deliberately choose to liquidate the banking system.
It always appears preferable, in the short term at least, to preserve the incumbent institutions and personnel through bail-outs. (Lending to “solvent but illiquid” firms at below-market rates is another kind of bail-out, even if it is not always called one by the authorities.)
Bankers thus have every incentive to become as “systemic” as possible and to take as much as risk as possible—they know that they can almost always get these bail-outs when they need them. Moreover, the liability of the big risk-takers (i.e., the mid-level traders rather than the executives) is often quite limited.*
They keep all of the upside when times are good and leave the rest of society with the tab when their bets go south. The Bank of England’s Andrew Haldane has argued that, if you properly count the cost of crises and hidden subsidies, banking as currently practised may not actually add any value.
Policymakers have been trying wrestle with these problems for more than a century, most recently with the Basel accords and America’s Dodd-Frank law. But, according to The Bankers’ New Clothes, a powerful new book by Anat Admati and Martin Hellwig, these reform efforts failed to address the basic problem of the crisis: banks are too fragile.
The authors persuasively argue that the solution is higher levels of equity capital throughout the banking industry as a way offset the impact of the implied government protections against failure.
Banks, just like other firms, can fund their investments by borrowing, by issuing shares, or by retaining earnings. Unlike other firms, however, banks appear to love borrowing and are allergic to equity, often funding more than 97% of their asset portfolio with debt. This makes it extremely challenging for banks to absorb even moderate losses.
Short-term lenders to banks, particularly those not protected by deposit insurance, have every reason to be skittish when they know that there is so little loss-absorbing capital available to shield them. In other words, thinly-capitalised banks are very vulnerable to runs, which are behind every single bank failure.
If a bank incurs losses but does not fail, it is often because it got a bail-out from the rest of us through some combination fiscal transfers, regulatory forebearance, and accomodative monetary policy. More equity would neatly solve these problems, which is why Ms Admati and Mr Hellwig recommend a minimum ratio of tangible common equity to total assets of about 25%.
Bankers, however, are steadfastly opposed. When confronted, they deliberately obfuscate the issue with meaningless phrases like “hold equity” and “set aside equity”, to imply that equity is an inert asset that could have been a productive investment in the economy.
Bankers also like to say that there is trade-off between safety and growth, arguing that higher capital requirements make it more costly for banks to create credit. The theory is that equity is more expensive than debt.
Regrettably, non-specialists in politics, the media, and the general public often fall for these tricks. However, Ms Admati and Mr Hellwig, along with many other finance scholars ranging from Eugene Fama to Simon Johnson, argue that the bankers’ narratives are based on bad economics.
To understand why bankers love the status quo you have to understand how they pay themselves. Unlike most enterprises, labour actually has more power than capital at the big banks because debt plays such a huge role on bank balance sheets.
To make shareholders feel better about this quasi-Marxist relationship, bankers use “return on equity” as a way to justify their compensation. The easiest way to maximise ROE is to minimise the stock of equity outstanding and borrow as much as possible.
Conveniently for the bankers, this also ensures that shareholders remain relatively powerless. (For more on the special incentives driving bank behaviour, see this earlier post.) It all helps explain why banks never seem to alter the absolute value of their outstanding equity:
After all, if banks were really concerned with minimising their funding costs, they would issue and retire shares opportunistically. Instead, all of the shrinkage and growth of bank balance sheets comes from changes in debt. Clearly, there are reasons for this behaviour besides the cost of capital.
It is worth reiterating that the cost of bank debt is suppressed by government subsidies, unlike bank equity. Thanks to deposit insurance, lenders-of-last resort, and the implicit guarantee that creditors will not face losses during any bail-out of a “systemic” institution, banks can borrow at much lower rates than other businesses, much less businesses with capital structures that are even remotely as fragile as banks.
The implication is that the existing arrangement constitutes a subsidy for bankers to enrich themselves while putting the rest of society at risk. Ms Admati and Mr Hellwig compare them to chemical companies that earn fat export profits because they are not penalised for dumping toxic waste in the rivers of their home countries.
The real question for policymakers is whether higher equity capital requirements would raise the cost of bank funding above what it would be right now in a world without these gifts from the rest of society. Empirical studies of America and Britain in the 19th century, before the establishment of the safety net, suggest that the answer is “no”.
The cost and supply of credit was not meaningfully different despite the fact that equity capital ratios were far higher. (My colleague nicely summarised that research here.)
To be clear, higher equity capital requirements do have one cost: they would be very bad for people who work at banks. The benefits, however, would more than redound to the rest of society by making the financial system safer. Well-capitalised banks maintain their lending during downturns. Those on the verge of insolvency do not.
We also see that among the big banks, those with lower leverage are perceived by the equity markets to more valuable, as a percentage of their book value, than those with higher leverage. In other words, higher equity/asset ratios may actually lower funding costs.
Existing shareholders, however, are not interested in getting diluted, although new investors would be interested in buying attractively priced shares. Bankers would not be interested in dilution because it would lower ROE and their own pay.
The most straightforward way to maintain ROE while issuing more shares is to cut costs, the biggest of which is labour compensation. The better deal for shareholders is to cut pay (and/or fire workers) and use the savings to buy back bank debt, which would reduce leverage without dilution.
Unsurprisingly, both options are undesirable to the bankers, hence the lobbying effort and dissimulation. They are obviously entitled to express their opinions in a free society, but that does not mean we should be taken in by their self-serving arguments.
There is another interesting, but not insurmountable, objection to higher equity capital requirements. I will discuss that in a subsequent post.
*At some firms, the structure of bonuses is beginning to change. But compensation schemes still fail to adjust for risk.
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