Most companies would think twice before operating at a debt to equity ratio (or leverage) of 2:1. Some capital-intensive businesses, such as shipping, opt for a ratio that is considered outlandish say, 5:1. But banks really take the cake. A leverage of 25:1 is not uncommon in banking. During the fi nancial crisis, there were large banks and investment banks that operated at ratios of 40:1 or more.
Such levels of leverage render banks fragile. Since banks are interconnected to a high degree through the payments system and in other ways, the fragility of an individual bank can translate into fragility of the entire banking system, especially if the bank happens to be large.
The collapse of banks carries enormous externalities, so banks are not easily allowed to fail. They are supported through insurance guarantees, central bank lender-of-last-resort facilities and the like and when they do fail, they are bailed out by taxpayers.
Why banks have been allowed to carry on thus and what needs to be done to render them less fragile is the subject of a recent book (The Bankers’ New Clothes, Anat Admati and Martin Hellwig, Princeton). The book deserves to be read by both bankers and policymakers as it debunks many of the myths that have been used to justify excessive leverage in banking. Much of what the authors say is standard corporate finance. It is useful, however, to remind bankers that they are not exempt from the basic propositions of corporate finance. Let us begin with some common myths and then move on to the authors’ answer to instability in banking.
Myth 1: It makes sense for banks to have high leverage because debt is cheaper than equity. This contention would sound highly plausible to laypersons. If you have to pay 8% on a debt instrument, equity could cost 15% or more. So having more debt results in lower funding costs for banks. This, in turn, translates into cheaper funds for borrowers.
The contention is flawed in more than one way. First, the cost of debt is not independent of the amount of debt that a firm has. As the amount of debt in the capital structure of a firm rises, the cost of debt itself will rise – and rise sharply beyond a certain level of debt. If it were not so, firms could be 100% debt financed. Secondly, the cost of equity is also not independent of the level of debt. The greater the debt, the greater is the risk to equity holders, so they will demand a higher return on equity (ROE).
As the authors correctly point out, what matters is the overall funding cost. The well-known Modigliani-Miller Proposition 1 in corporate finance states that the cost of capital is independent of the mix of debt and equity. In the real world, however, the mix of debt and equity matters because of imperfections such as taxes. This does tilt the argument in favour of debt but only a little. Beyond a certain level, the tax benefit of debt would be overwhelmed by a higher probability of firm failure and the associated bankruptcy costs.
Myth 2: High leverage increases return on equity, which is good for investors. The higher the leverage and the lower the equity, ROE does rise. But so does the rate of return required by equity investors. This is because a greater level of debt increases risk for equity investors. And the higher the risk they are asked to bear, the higher is the return they will require to compensate them for the risk.
The greater the equity the bank has, the lower is the ROE that investors will demand. This makes nonsense of bankers’ claims that compelling them to hold more equity will make it harder for them to meet the ROE targets. It is not as if the ROE target is cast in stone, it depends on how much leverage the bank chooses to have.
Moreover, in banking, ROE is a highly deceptive measure of performance. Banks can achieve a high ROE by taking excessive risk. The costs of these risks will show up down the road. In the short run, bank managers can impress the market with high ROE figures. This is exactly what happened with many of the banks that went under during the financial crisis.
Myth 3: Banks are special in many ways. Much of their debt is in the form of low-cost deposits. Moreover, since the deposits are of short maturities whereas the banks’ own lending is of longer maturities, banks are inherently fragile. It is true that banks pay lower interest in deposits (and zero interest on current account deposits) because they provide customers with many services against their deposits. However, these services entail costs that are not always fully charged to customers and these costs must be added to the interest paid to depositors. Banks also have to pay insurance fee against insured deposits and this too adds to the cost of deposits. Moreover, deposits are not the only borrowings banks have. For many banks, non-deposit borrowings exceed deposits.
It is also not true that banks are fragile simply because depositors can ask for their money back whenever they like. Central banks are there to provide liquidity to banks and banks can themselves protect themselves against liquidity risk by parking adequate funds with the central bank as cash reserves. Again, banks do not become fragile because they take short-term deposits; it is their use of these deposits or the risks they take in lending and the amount of equity they hold that determines bank fragility. When banks rely heavily on borrowed funds and use these funds to make risky investments, they become vulnerable.
These myths are part of the rhetoric that bankers use all the time. The authors contend that they are an illusory something – rather like the fabled emperor’s new clothes – that bankers have created in order to justify high leverage. This raises the question: why would bankers want to persist with high leverage, knowing that it renders banks fragile?
The authors highlight two clear motivations. One is that the implicit guarantee of bank debt, provided by government, lowers the cost of borrowings for banks. The cost of borrowing for banks is lower than the market rate because of the implicit subsidy for bank borrowings. The cost of the subsidy is borne by society at large. In other words, taxpayers are paying for banks’ cheaper debt and it suits bankers to carry on this way.
Two, bankers’ incentives are linked to ROE, which is easily boosted by having low equity or high debt. A high level of borrowing creates incentives for managers to take huge gambles: if the gambles pay off, they stand to reap enormous rewards; if they do not, shareholders and creditors get wiped out. There is widespread recognition now that ROE is a flawed measure of performance and that incentives are better linked to total return on assets and are also paid out over a long period. But it has taken a major financial crisis for realisation to dawn.
The case for boosting equity in banks is thus clear as daylight. The practical question is: what should be the appropriate level of equity? The enhanced capital requirements under Basel 3, the authors make clear, are far from adequate. Many will find their own proposal rather radical, but it is hard to fault the underlying logic.
Basel 3 envisages an increase in total bank capital – or capital adequacy – from 8% of risk-weighted assets to 10.5%. Tier I capital will go up from 4% to 7%, with most of it being core equity. Banks typically operate about four or five percentage points above the regulatory minimum. So, we can expect that, as a result of the Basel 3 norms, banks will have capital adequacy of around 15%. Is this level adequate for banks to cope with a crisis of the sort we have seen recently?
Banks absorbed losses during the crisis of 2007 equivalent to 7% of assets. So setting a capital adequacy level of 7% should help the bank survive. However, the journal, quoting Anil Kashyap of Chicago University, says that if a bank is to continue lending after having absorbed losses in a crisis, capital may have to go up to 15%. This, as we pointed out above, is roughly where we can expect banks to be after Basel 3.
Raising Equity
The authors, however, have little patience with the risk-weighted approach adopted under the Basel norms or with capital allocation based on banks’ internal models. Risk weights of zero for government securities have been proved false in the Eurozone crisis. Triple A-rated securitisation packages were loaded with poor quality securities and caused enormous losses to banks. Internal models, the authors believe, allow banks to manipulate risk assessments so that they can get away with carrying very little equity.
More importantly, under the risk-weighted approach, equity as a proportion of total assets will be a mere 3% even after Basel 3. This is still a staggering amount of leverage by any reckoning. A mere 3% drop in the value of assets will render banks insolvent.
Enough is enough, the authors say. Stability in banking can be achieved only with a significantly higher amount of equity capital in the system. The authors propose a level of equity of 20%-30% of total assets. This will cause bankers and regulators alike to gasp but the authors do not believe that their proposal is unrealistic at all. Before we had deposit insurance and when banks were subjected to market discipline, they point out, such levels of equity were quite common in the banking system.
Will banks be able to raise the necessary capital? The authors demolish concerns on this score. Capital is always available at the appropriate price. Where banks cannot raise capital, they should be asked to retain all earnings and refrain from paying dividends. If banks cannot generate enough profit to augment capital and if they cannot raise fresh capital either, they are probably insolvent and deserve to be shut down.
There is merit in these propositions but it is hard to accept the authors’ claim that increasing banks’ equity from 3% to 25% of assets involves “no cost to society whatsoever”. Banks may choose to meet higher capital requirements by cutting back on lending or what is called deleveraging. This is already happening under Basel 3 norms and is affecting global economic growth. Any substantial increase in capital requirements is bound to aggravate the impact. Bank capital does need to go up significantly but there is a case for phasing out the increase over a reasonable period.
It is hard, however, to refute the basic point of the book: banking can be made more stable and recurring banking crises avoided only by getting banks to hold far more capital than is envisaged today. Doing so may also render unnecessary some of the other reforms being talked about by way of controlling systemic risk, such as limiting the scope or size in banking. Bankers find these reforms unpalatable as well and have been lobbying hard to fend them off. Perhaps, it is time to confront them with a choice: a much higher capital requirement or restrictions in scope and size.
