Professor Anat Admati, one of the distinguished economists who were recently widely noted as calling the bluff on bank CEO assertions about the negative effects of stricter capital requirements, has written a letter addressing the nonsense touted in the Financial Times by such bankers and their supporters. Since many readers will not have access to the proprietary material at the Financial Times, I thought you would enjoy seeing her letter here (republished with Professor Admati’s permission) and at the following link:
Highly Leveraged Banks Inflict Great Suffering on Society
Text of Letter published in Financial Times, December 2, 2010
George G.C. Parker Professor of Finance and Economics
Graduate School of Business
David Miles’ column (“Banks fail to convince crying foul over Basel reforms”, November 24) and his follow up letter (“Don’t dismiss Modigliani and Miller logic on bank funding,” November 30) in response to letters by Messrs Barwell, Gleeson and Samuels on November 29, were refreshing, particularly following Citi CEO Vikram Pandit’s previous comment (“We must rethink Basel or growth will suffer,” November 10).
Unlike Pandit and the November 29 letter writers, Miles focused on the logical arguments. Mr. Samuels used a quote by baseball star Yogi Berra to dismiss Miles arguments as theoretical and inapplicable to practice. But Yogi Berra is also famous for instructing a waiter to cut his pizza into six slices because he is “not hungry enough for eight slices.” This is funny precisely because the size of a given pie doesn’t depend on how many slices it is cut into, an exact analog to Modigliani and Miller’s result.
This is true in theory and no less true in practice. The reason that high leverage lowers banks’ funding costs is that the more debt banks use relative to equity in their funding, the smaller is the slice the government takes in taxes, and the higher is the value of the implicit or explicit guarantees the government provides to their debt.
Highly leveraged banks, particularly those too important to fail, have strong incentives to take on excessive risk, enjoying the upside without having to worry about the downside of their bets. Given the fragility and systemic risk that high bank leverage entails in our interconnected financial system, society suffers greatly when banks are highly leveraged, even as banks and their managers benefit. When it comes to banks and their leverage, there are no practical considerations associated with bank funding that provide any reason for the public to allow banks to be anywhere near as highly leveraged as they would like to be.
Messrs Pandit, Barwell, Gleeson and Samuels must do more than dismiss arguments as theoretical and raise vague and unsubstantiated threats to global growth and the economy. They must explain precisely what forces should lead society away from imposing high equity requirements on banks and how such an effect comes about. Unless and until they do so, it is their arguments that should be dismissed and not Miles’.