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Too Much Equity? If Anything, Brown-Vitter Asks Too Little

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In a recent column William Isaac warns that the Brown-Vitter bill "will do far more harm than good." The bill, introduced by Senators Sherrod Brown, D-Ohio, and David Vitter, R-La., would require the largest banks to maintain higher equity levels than current or proposed regulations demand. Mr. Isaac actually agrees with the intent and with key parts of Brown-Vitter, but he recommends a substantial long-term debt requirement in lieu of the additional equity that Brown-Vitter requires for megabanks with assets over $500 billion.

Long-term debt is a poor substitute for equity, particularly for the largest banks. If anything, Brown-Vitter does not go far enough in raising equity levels. Requiring even more would enable banks to absorb more losses without becoming distressed, failing, or needing taxpayer support. Better yet, having more equity would improve the banks' ability to perform all their useful functions, including deposit-taking and lending. Requiring more equity is the simplest and most effective way to reduce the large distortions associated with the banks' high indebtedness and to prevent instability and crises.

Isaac recognizes the benefits of requiring more equity. He recommends requiring 8% tangible equity relative to total assets, significantly more than current regulations require and the same as Brown-Vitter mandates for banks between $50 billion and $500 billion in assets. Also like Brown-Vitter, Isaac's proposal avoids relying on the complex, distortive and manipulable system of risk weights used in the Basel standards to determine capital requirements.

The only difference: Mr. Isaac's 12% long-term debt requirements would replace the additional 7% tangible equity that Brown-Vitter requires for banks with assets above $500 billion, currently just the largest six.

Isaac claims that higher equity requirements would harm credit and growth. This claim rings hollow, since a system of better capitalized institutions is more resilient to downturns and less prone to crises. The 2008 financial crisis resulted in the largest decline in output since the Great Depression and in a credit freeze that led the U.S. government and the Federal Reserve to provide unprecedented support to banks. These events were not due to banks having "too much equity," but rather to their distress as a result of heavy borrowing and subsequent losses. Mervyn King, the outgoing governor of the Bank of England, said recently: "Those who argue that requiring higher levels of capital will necessarily restrict lending are wrong. The reverse is true. It is insufficient capital that restricts lending."

Excessive borrowing generates inefficiencies. This dark side of borrowing is a key reason it is rare for healthy companies to become heavily indebted, even though there is no regulation preventing it and the corporate tax code encourages debt over equity funding. Nothing about banking makes equity levels below 25% essential, unavoidable or efficient. In fact, it was common for banks to maintain such levels or even higher ones before they had access to so many safety nets. The banks' depositors and other creditors insisted that banks have more equity, just like prudent banks, acting as creditors, require from those they lend to.

The claim that more equity would harm lending is rarely challenged, but why would it be true? For example, since the large banks are currently profitable, why can't they retain their earnings and make loans? They can take a cue from Warren Buffett, whose Berkshire Hathaway always retains its earnings and invests. Retained earnings are a key source of funding and growth for most companies, one that does not require borrowing.

Lending is actually only a part of what large banks do. JPMorgan Chase (JPM), for example, has at least $300 billion of "excess deposits," some of which were invested in derivatives in London. Loans make up less than a third of JPMorgan's assets under generally accepted accounting principles. The problem if banks don't lend is not the lack of funds or an inability to increase equity; rather, it is the bankers' lack of incentives or desire to lend or to raise equity, and their preferences for other investments and for continuing to rely on borrowing.

Borrowing creates conflicts of interest between borrowers and creditors, and these conflicts distort investment decisions. Heavy borrowers may avoid investments that benefit the creditors at the borrowers' expense, and they might be biased towards risky investments that benefit themselves at the expense of creditors. Distressed homeowners, for example, might not invest in maintenance or home improvement. Taking out a second mortgage exposes the lender that wrote the first mortgage to increased risk of default and foreclosure just like the payment of dividends by a highly indebted corporation puts its creditors at higher risk.

Since they rely on so much borrowing, banks are strongly influenced by such incentives. Making a boring but worthy business loans might be unattractive to bankers, particularly those working for the largest banks. Investments in traded assets or derivatives that have more upside and are more easily "scaleable" are likely to be more attractive, particularly if bonuses depend on short-term profit measures. Deposit insurance and guarantees greatly exacerbate the distorted incentives, enabling banks to continue to borrow repeatedly and take risk without complaints from their existing creditors. The deposit insurers or taxpayers are harmed including by the business loans that are not made. In a crisis, the harm can be larger.

The only way to alleviate these conflicts is to require more common equity. Any borrowing, including long-term debt, maintains the conflicts and exacerbates the inefficiencies of debt overhang.

Another problem with long-term debt relative to equity is its dubious capacity to absorb losses, especially in the case of the largest banks. The failure of a global megabank in the U.S. would entail the Federal Deposit Insurance Corp. exercising its yet-untested new resolution authority. But the FDIC lacks jurisdiction outside the U.S. Despite some progress with U.K. authorities, legal differences across countries will pose enormous challenges should a global bank fail.

Moreover, imposing losses or expenses from the resolution process on a bank's creditors or on surviving institutions, which themselves might be systemically important and likely to be weak at the same time, might further destabilize the economy in a crisis. Despite the Dodd-Frank Act reforms, we are likely to see taxpayer-funded bailouts again if policymakers view the alternative as worse. Even in the best scenario, a resolution process would be disruptive and costly. Equity, by contrast, absorbs losses without such complications.

The notions that "excessive" equity will hurt the economy, that debt funding is "cheaper" or better than equity in any way that is relevant to the policy debate, or that it is a policy objective to make sure "our banks" succeed in global competition, are among the claims that my colleague Martin Hellwig and I have debunked in our book "The Bankers' New Clothes: What's Wrong with Banking and What to Do about It" and in a subsequent summary document . I hope those who make such claims or believe them to be true will take the time to consider our arguments. The public deserves a safer and healthier financial system that supports the economy without exposing us to as much risk, distortions and harm.


Anat Admati is a professor of finance and economics at Stanford University's Graduate School of Business.

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Comments (4)
Following this logic, why not require 100% capital? The problem articles such as this ignore is the need to attract capital. Banks typically earn about 1.25% to 1.5% on assets in good times. If that was the return on equity investors would flee to manufacturers and retailers who earn far higher rates on equity. A balance must be struck between safety and soundness and attracting investors to banks. Raising minimum capital standards will tend to limit a bank's ability to raise capital. It will reduce returns on equity and the easiest way for a bank to raise its capital level is to stop lending, which shrinks bank's share of credit. Ignoring this factor is a common theme among politicians and academics. The result has been a constant shrinking of the banking sector as providers of credit since WWII when banks provided 60% of all the credit in the nation. Today banks provide about 20% of all credit. Capital flows freely to the shadow banks but is increasingly constrained for depository banks.
Posted by amuranaka | Monday, June 24 2013 at 2:15PM ET
100% capital would not allow deposits, and deposits are useful.

There was not enough space in a short piece to explain everything, hence the last paragraph. All these issues (ROE, cost of capital, credit provision, shadow banking, etc) and more are discussed in detail in the book. You can see brief responses in the linked document http://bankersnewclothes.com/wp-content/uploads/2013/06/parade-continues-June-3.pdf
Posted by admati | Monday, June 24 2013 at 5:35PM ET
I understand that 100% capital would eliminate deposits. I was highlighting that safety is not the only factor in setting capital ratios. It is unquestionably true that raising capital ratios would make banks safer. It is also very simplistic. Safety and soundness is one purpose for capital. We also want banks to provide safe places to deposit money, to extend credit, to earn a profit, and be able to attract investors. All of those purposes factor into setting the best capital ratio, but credit, profit and attracting capital are often ignored, and that has driven capital away from banks. That, in turn, has been bad for the nation because banks are the best regulated lenders (not perfect, but better regulated than securitization trusts).

Brown and Vitter want to drive the largest banks out of the business. That is why they would raise capital. They apparently understand how shallow the pool of investors has become for banks and how the pool can be drained even more. At the same time, the mounting array of regulations, requirements, etc are driving smaller banks out of the business. I know of medium size banks that are healthy but their shareholders are looking for way out because the return on their investments is too low. When is someone going to finally ask how much we can pile on before banks fade into insignificance?
Posted by amuranaka | Monday, June 24 2013 at 6:25PM ET
My findings support the professor's position, however for some other reasons that nobody talks about. Large banks ($100 billion plus in assets) in times of economic euphoria take on more risks than non-large banks. Moral hazard likely plays a role and pressures of major stockholders, etc. Therefore, large banks ought to have more capital than non-large banks to protect the FDIC insurance fund and the need to be bailed out in times of a crisis. Secondly, Basel capital requirements have incentivized large banks to shy away from corporate lending since they are penalized for such relative to other use of funds given the Basel capital framework. Such other uses of bank funds constrains liquidity and increases the chance of extreme losses in a one-off event (i.e. fat tail risks).

Personally, when I was heading the FDIC's large bank oversight program during the period leading to the bank crisis, I found that the FDIC ignored its risk model showing LIDI (large bank) risks were significantly rising relative to all commercial banks in 2005, 2006, 2007 and 2008.

All of the large banks with the exception of Citigroup had Leverage capital in the period leading up to the banking crisis of roughly 6% or more. Here is a sample of the six largest banks plus Merril Lynch. Notice, each of the banks had leverage capital that is what is now being proposed by regulators for the Basel international capital accords. Obviously, a 6% capital we know was not adequate to protect these large banks from failing or needing to be bailed out by the government in the aftermath of the crisis. So, we can see that 6% is not adequate going forward.

Also, look at the Basel II capital ratios that each bank reported as being adequate for their needs in the period leading up to the crisis. The large banks had leverage capital of 6% or more. These ratios, as we know, were woefully inadequate. Going forward with 6% proposed requirement for leverage capital will provide inadequate protection once again to shareholders and the government should they get into trouble during the next downturn in the economy. By the way, I reported to FDIC officials the inadequacies of Basel II upon completing a detail to go work on the accords at the Bank for International Settlements. Unfortunately, FDIC officials ignored my warnings.

One can go to my blog and see more about these revelations, going back 3 or 4 postings.

http://govwhistleblower.wordpress.com/
Posted by Dwihas3 | Monday, July 01 2013 at 7:25AM ET
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