Capital Idea

As regulators and banks argue over new rules to prevent another financial meltdown, and how to plug loopholes or prevent fresh regulation throttling regular banking operations, a proposal for higher equity capital might help reduce the massive risks that high reliance on loan financing involves > By Mark Hager

By Echelon.

Published on July 10, 2013 with No Comments


Maybe it’s all very simple.  Such is the takeaway from ‘The Bankers’ New Clothes,’ an important new book by Anat Admati and Martin Hellwig.  They cite insufficient equity capital as contemporary banking’s fatal flaw.  Financial sector stability requires mandating higher equity levels. Since the 2008 financial crisis, ideas have proliferated as to what should be done about the banks. Is the key problem size, recklessness or interconnectivity? Some focus on the ‘too big to fail’ (TBTF) problem, spotlighted harshly by the massive taxpayer bailouts of 2008, and propose limits to bank size. Consolidation in the financial sector has never been greater. As of 2009, the big four—Bank of America, Citicorp, JP Morgan Chase and Wells Fargo—held some 40% of total deposits. Market share of the ten largest stood at 60%, up from 25% in 1990.

By 2012, the big four held 54% of total assets. But size limit proposals confront questions of specification, compliance and utility.

First, how should size limits be specified? Out of the fog have come competing criteria:  no more than 10% of total national deposits; no more than 10% of total national loans; no more than 10% of risk-adjusted liabilities; assets no more than 10% of GDP; non-deposit liabilities no more than 10% of GDP; and – last but not least – assets no more than 5% of the current targeted value of the Deposit Insurance Fund administered by the Federal Deposit Insurance Corporation!  Where do we find guidance in choosing among these options?

Of course, the exact criterion may matter less than the sheer existence of a maximum. But a second set of questions concerns compliance. What sanctions apply for non-compliance and what steps does a non-compliant bank take to get into compliance? A third set of questions concerns utility: how much good would size limits do and what harm might they cause? Reckless investment and financial interconnectivity could surely produce financial meltdowns and bailouts even without megabanks. Meanwhile, would arbitrary size limits undermine performance incentives for banks near the line?

Some observers urge focusing less on size, more on reckless investment itself. Over the past two decades, Wall Street has followed a business model of speculating massively in risky securities. Regulation to curtail this confronts the difficulty of banishing harmful forms of trading without constraining beneficial ones. The ‘Volcker Rule,’ enacted with the Dodd-Frank reform act of 2010, bans banks from ‘proprietary trading’: buying and selling securities for their own profit rather than on behalf of clients. Like all gambling, proprietary trading yields no aggregate economic benefit: every gain equals someone else’s equivalent loss. By destabilizing both players and markets, it arguably harms the financial system.

Proponents contend that the Volcker Rule will ensure a more stable and secure credit system. Banks protest that the sheer complexity of this will gum up their operations, while reformers worry that the final product will be a Swiss cheese of loopholes.

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Admati and Hellwig see as the key battle ground not size or reckless investment, but interconnectivity. Interconnectivity risks escalate as banks rely increasingly on loans from outside creditors to finance their operations.  In the first half of the twentieth century banks operated with equity capital equalling twenty to thirty per cent of assets. Today, equity/asset (E/A) ratios hover down around two or three per cent. This shift indicates a massive trend away from equity toward loan financing. This puts banks at higher risks of insolvency and magnifies transmission of risk through the interlocking financial sector. Banks of course use borrowed funds for any and all operations, including proprietary trading.

A new reform bill hit Congress in May, designed to curtail leverage (borrowing) among the biggest banks. Co-sponsored in the Senate by Democrat Sherrod Brown and Republican David Vitter, the bill appears to be inspired directly by Admati and Hellwig. It would require banks with assets over $500 billion to maintain equity—aggregate share values plus retained earnings—equalling at least 15 per cent of total assets.

Brown-Vitter could eliminate some of the advantage from low borrowing costs enjoyed by TBTF banks, while cutting their insolvency risks and reducing both the likelihood and magnitudes of credit meltdowns and taxpayer bailouts.  By definition, equity equals aggregate assets minus aggregate liabilities. Brown-Vitter essentially requires big houses to maintain higher margins between assets and liabilities.  This would force them to reduce their use of borrowed funds (which create liabilities) to finance themselves.

Low bank equity encourages risky investment by shifting loss exposure from shareholders to creditors. It heightens dangers and market fears of insolvency when bank asset values decline. A bank with only two per cent equity stands on the brink of insolvency if its asset portfolio declines just one per cent.

Moreover, low equity makes it harder for stressed banks to raise emergency loans. And by forcing asset sales when liquidity tightens or loans come due, it creates cascades of declining asset prices, eroding the portfolios of all banks holding such assets. Danger and fear gush through the system. Lending to firms and households dries up as banks hold cash to repay their creditors.

By contrast, a high ‘equity cushion’ allays fears of loan defaults and depositor ruin by pushing losses onto shareholders with only ‘soft’ claims on bank wealth. There is no rush to asset sales because declining equity value absorbs the impact of portfolio declines without instant insolvency.

Critics of Brown-Vitter raise several objections.  One is the vague notion that bank equity represents funds ‘set aside’ and unavailable for lending or other investment. This objection is pure canard, confusing equity with reserves. Bank reserves are indeed set aside from active operations, thereby providing self-insurance against insolvency.  But equity requirements concern how banks raise funds, not at all what they do with those funds. Equity capital is fully available for lending and other investments.

capital-idea quote1A second objection is that mandating high E/A ratios would curtail availability of loan funds and thereby saddle firms and households with higher borrowing costs. Bank assets consist largely of rights to collect on loans made. Imagine a bank with $10 billion equity and an E/A ratio of two percent.  If its assets consist entirely of outstanding loans, that comes to $500 billion (10/500=.02).  If legally required to hike its E/A ratio to 20%, its equity can support only $50 billion in loans outstanding. To conform with the law, it must shrink its loan portfolio tenfold. The resulting credit contraction is disastrous, say Brown-Vitter’s critics.

But shrinking A is not the only way to increase E/A.  One could also increase E while holding A constant. Our bank can continue with $500 billion in loans outstanding at an E/A ratio of 20% by raising its aggregate equity to $100 billion. It can do so by selling more shares, by retaining more earnings rather than issuing dividends, or both. So mandating higher E/A need not yield credit contraction.  It all depends on how banks respond to the mandate and on how law shapes incentives to respond one way or the other. During a specified grace period, for example, laws could ban dividends and require new equity issues for banks falling below the mandated E/A ratio. There might indeed be mischief in the details and the stakes are unquestionably high, but if objectives and dangers are clearly understood, transition without credit contraction may be feasible.

Fine, but isn’t it wrongheaded to supersede the market in shaping bank financials? If the banks all favour leverage over equity, it must be market forces finding efficiency, right? No.  There are at least two powerful reasons to doubt that bank preferences for leverage embody market-determined efficiency.

First, management representing existing equity favours leverage because it displaces the risk of dangerous investments from shareholders to outside creditors. Those outside creditors meanwhile displace their own risks onto taxpayers in TBTF bailouts. The leverage favoured by shareholders and tolerated by creditors represents loss-shifting that skews incentives away from aggregate efficiency.

Second, the tax code favours leverage over equity. Because loan repayments are treated as a business cost, firms (including banks) pay no taxes on them. Dividends on equity, by contrast, must be repaid out of earnings after corporate taxes. Hence, the tax code covertly creates an incentive for banks and their investors to favour loans over equity financing: they can split the value of loan capital’s tax exemption.  The resulting leverage preference is an artefact of public policy, wise or unwise as may be, not pure market forces. (Here again, taxpayers subsidize leverage by paying higher taxes to support government than would be needed if firms paid taxes on earned revenues before repaying creditors.) In this light, Brown-Vitter’s hiked E/A mandate is less a market distortion than a counterweight to a prior one.

In assessing Brown-Vitter, we should of course listen to its bank sector critics. But lest we be dazzled, we should bear in mind their business model of shifting risk from them to us.

 >  A graduate of Harvard Law School, Mark Hager lives in Pelawatte and consults on complex legal and writing challenges. He also provides training on negotiation skills with Sea-Change



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