Our largest banks failed to build cushions to absorb losses even while knowing back in 2007 that the music would soon stop playing and (to mix a metaphor) the debt-fueled asset bubble would burst. As it happened, externalizing their losses worked out well for the bankers, but not for the rest of us. It is a mistake to repeat this cycle. And, yet we are doomed to suffer the consequences of others’ follies if we don’t require banks to lightened up on debt and build up their equity capital reserves.
While most banks resist the idea of cutting back on their borrowing, claiming it is “too expensive,” some bankers and experts disagree. In a recent Bloomberg story about the delay in higher capital requirements, former Citigroup CEO, John Reed questioned why “We continue to listen to the same people whose errors in judgment were central to the problem.” Better that we listen to Professors, Anat Admati, Peter DeMarzo, Martin Hellwig, and Paul Pfleiderer, authors of “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive.” Lawrence Baxter recently discussed this study in his Pareto blog entitled,”whose risk is it? bank capital, basel iii, and the bankers.” A November op-ed signed by 20 professors and published in the Financial Times as “Healthy banking system is the goal, not profitable banks” explains why equity is not expensive. This group included Nobel Laureate William Sharpe and Eugene Fama.
“Bankers warn that increased equity requirements would restrict lending and impede growth. These warnings are misplaced. First, it is easier for better-capitalized banks, with fewer prior debt commitments hanging over them, to raise funds for new loans. Second, removing biases created by the current risk-weighting system that favor marketable securities would increase banks’ incentives to fund traditional loans. Third, the recent subprime-mortgage experience shows that some lending can be bad for welfare and growth. Lending decisions would be improved by higher and more appropriate equity requirements.”
As Lawrence Baxter highlighted here in “yogi berra on leverage,” Professor Admati explains:
“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.”
For a quick sense of what regulators can do right now, one can turn to Professor Admati’s January 19, 2011 op-ed in the Financial Times. In “Dividends Can Wait Until Banks Are Stronger,” she cautions against the Federal Reserve permitting big banks to pay out increased dividends to shareholders. Instead, in her view, they should build up, not shrink their equity capital cushions. In other words, paying shareholder now, means wearing away the protection the banks have to withstand future market turmoil, thus increasing the odds they will externalize their losses, leaving the taxpayers and other investors who suffer from a deleveraging spiral to foot the bill.
Bank holding companies that still fund their operations with massive debt will continue to create risk to the public.These behemoths that are bloated on debt could and should slim down. Even today, the Admati op-ed explains, they are highly leveraged and owe at least $95 for every $100 in assets they own. The remaining $5 in equity is hardly sufficient. With this type of balance sheet, if asset values fall by a mere 5%, the firm is insolvent. And, of course, well before insolvency, the pressure to raise capital by selling the more valuable assets, will pressure others who own similar assets, driving down prices and thereby pressuring other banks to also raise capital, the downward spiral.
How sensible is this? Is there a safer amount of equity capital? Admati notes that non-financial firms, hold much more equity capital. They borrow just about $30 for every $100 in assets they own. This leaves about $70 in equity to absorb losses. And, some firms like Apple and the Gap have virtually no debt financing.
What is the ideal for financial firms? In, “Basel III: The Fatal Flaw,” Simon Johnson, Professor and former Chief Economist for the International Monetary Fund suggests at least 15% in “good times.” This equity of 15% was also put forward in November FT in the letter signed by 20 professors, mentioned above. The letter stated that:
“If a much larger fraction, at least 15 per cent, of banks’ total, non-risk-weighted, assets were funded by equity, the social benefits would be substantial. And the social costs would be minimal, if any.” (emphasis added).
Others argue for even more of a cushion. For example, Martin Wolf, FT chief economics commentator and economics professor in “Basel: the mouse that did not roar,” recommends 20-30% equity capital to assets without risk-weighting.
Has the Dodd-Frank Act or the Basel III accord made things better? Not much as of yet. Under the hard-won “Collins Amendment” in Dodd-Frank, for example, bank holding companies must follow at least the same requirements as insured depository institutions (the banks where savers keep deposits and that are insured by the FDIC) when it comes to both leverage and risk-based capital. In terms of leverage, for insured depository institutions (IDIs), 4% equity is considered “adequately capitalized.” Though 3% is permitted for certain IDIs. And, getting that imposed on bank holding companies was the result of a fierce legislative battle. Prior to that, there had been no statutory limits on leverage of bank holding companies (or the giant investment banks that took on the bank holding company designation in 2008 to gain federal support). Many were leveraged as high as 30 to 1 or 40 to 1, or just 3.3% – 2.5% in equity.
Also under Dodd-Frank, those bank holding companies with $50 billion in assets (as well as so-called systemically important “nonbank financial companies”) may have to hold more equity capital. Of this special group, those that the new super-regulator, the Financial Stability Oversight Council determines to pose a “grave threat” to the financial stability of the US will be required by the Federal Reserve to have a 15 to 1 debt to equity limit, or $15 borrowed to finance $16 in assets, a mere 6.25% in equity. While the legislation permits regulators to impose even greater equity capital requirements, this is not hard-wired into the law and requires willing regulators.
As for the Basel III accord, which does not have the force of law, but instead is guidance for the participating countries, it’s not much better. The Basel Accord would permit even less equity capital than Dodd-Frank, as low as 3%. That’s $97 borrowed to finance $100 in assets. If you read the report, you might miss this newly introduced leverage ratio. Details are buried on page 60-61. And, it may be temporary, as it is only a test, from January 1, 2013 to January 1, 2017.
While the Basel Accord also has a separate series of seemingly higher capital requirements, those measure tier 1 capital (largely equity), as well as other forms of capital relative to risk-weighted assets. Meaning, some assets are not counted fully in the denominator. Even if a bank owns $100 in assets which it used $97 to borrow, it can discount some of those assets. The discounting process is based on the expected risk that the asset will lose value. Some assets are held at their full dollar value, others more and others less. Some assets could be treated as if they did not exist. if they are considered using some straight-forward tests and also a variety of complex formulas. As an example, this could result in treating the $100 in assets like $30 in assets and thus $3 in relation to $30 looks more like 10%.
Risk-weighting, of course, is not new or necessarily nefarious, but in practice have been subject to manipulation. While these weights were intended, as the Economist recently described to “discourage banks from lending to risky enterprises, and to encourage the accumulation of apparently risk-free assets,” in reality they contributed “to the structured finance craze, as securitisation was a way to ‘manufacture’ apparently risk-free assets out of risky pools.”
Recognizing the limits of these risk-weighted measurements, the report wisely highlights the importance of a simple leverage ratio:
“One of the underlying features of the crisis was the build-up of excessive on- and- off balance sheet leverage in the banking system. In many cases, banks built up excessive leverage while still showing strong risk based capital ratios. During the most severe part of the crisis, the banking sector was forced by the market to reduce its leverage in a manner that amplified downward pressure on asset prices, further exacerbating the positive feedback loop between losses, declines in bank capital, and contraction in credit availability.”
“Therefore, the Committee agreed to introduce a simple, transparent, non-risk based leverage ratio . . . intended to achieve the following objectives . . .constrain the build-up of leverage in the banking sector, helping avoid destabilising deleveraging processes which can damage the broader financial system and the economy; and . . reinforce the risk based requirements with a simple, non-risk based “backstop” measure.”
However, 3% is just not enough. And, to be sure, limiting leverage alone is not sufficient. For example, regulators also need to pay close attention to maturity mismatch (using short-term, sometimes overnight, funding to support long-term illiquid assets). And, of course, inflated asset values and assets with “embedded” leverage, and assets and liabilities “hidden” off balance sheet need to be addressed. However, to dimiss the necessity of leverage limits is suspect.
Some contend that reducing leverage will have no value at all, suggesting that limiting debt is like limiting a person to “6 drinks” in order to avoid drinking binges. For example, commentator, Eric Falkenstein, writes, “they will switch from beer to wine, whiskey, or grain alcohol,” meaning the assets purchased will be of poorer quality but better yields initially. And, of course, asset quality is important, but the author does seem to ignore the possibility that the banks have been drinking grain alcohol all along. And we are still drinking their Kool-Aid.