Are Banks Bluffing About the Danger of Banking Regulation?

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People walk past the New York Stock Exchange during afternoon trading.

Four and a half years after the passage of TARP, one thing is abundantly clear: The American public really, really hates bank bailouts. And yet, nearly three years after the passage of the Dodd-Frank financial reform bill, it remains unclear whether our financial system is significantly safer, and whether taxpayers are any less likely to have to bail out another large bank in the future.

That’s why an increasing number of voices on both sides of the political spectrum have been pressing for additional reforms that would reduce the chances that the federal government will have to step in to save another big, dumb bank.

Adding to this chorus are financial economists Anat Admati and Martin Hellwig with an important new book called The Banker’s New Clothes, which offers what the Dodd-Frank legislation mostly lacked: a simple and elegant solution to the problem of financial stability. They argue that banks should fund themselves with more equity and less debt — or, to put it bluntly, that banks should risk more of their own money, and less of everyone else’s.

Banks don’t want to do that, because they generally fund their operations with disproportionate amounts of debt, and they maintain that their profitability — as well as our economy’s growth — depends on their continuing to do so. The central point of Admanti and Hellwig’s book is that these protestations are like the emperor’s new clothes: There’s simply nothing there. They write:

“A major reason for the success of bank lobbying is that banking has a certain mystique. There is a pervasive myth that banks and banking are special and different from all other companies and industries in the economy. Anyone who questions the mystique and claims that are made is at risk of being declared incompetent to participate in the discussion.”

But let’s back up for a second to make clear why “more equity and less debt” would make our banking system safer. Just like any business, banks can fund their operations either by issuing shares (selling equity, or ownership) or by borrowing money. Many companies, like Apple for instance, fund themselves entirely through equity. Large banks, however, fund themselves almost exclusively by borrowing. (The authors give the example of Deustche Bank, which had “only 2.5% equity relative to their assets at the end of 2011.”)

(MORE: The Break-Up-the-Banks Drumbeat Gets Louder. But Is It Just a Bunch of Hot Air?)

One reason banks rely so heavily on debt is that the federal government encourages cheap lending to banks. For instance, anybody who has a savings account is technically lending their savings to the bank at extremely low interest rates. And the reason we accept such low interest rates is that 1) we can withdraw our money at any time, and 2) our deposits are guaranteed by the FDIC up to $250,000.

Then there’s the implicit guarantee given to large banks by the federal government: The bond market has increasingly come to believe that, in the event of a financial crisis, large banks will be rescued by the federal government, either through direct cash infusions or Federal Reserve lending. This belief effectively subsidizes the industry because it allows banks to borrow much more cheaply in the bond market than they otherwise could, making equity funding proportionately less attractive.

The problem with all this is that when large banks are funded by so much debt (and so little equity) they’re in much greater danger of insolvency during an economic downturn. This is pretty intuitive if you use a familiar analogy: Imagine that you bought house for $100,000 with only a 3% (or $3,000) down payment, and then the housing market slumped. A mere $4,000 decline in the value of your house would put you underwater. The same goes for banks when they are funded with excessively high debt levels: Small declines in the value of their assets can quickly render them insolvent.

Of course, this example also shows why debt financing is so attractive to those doing the borrowing: If the value of your $100,000 home instead increased by $4,000, you would have made a 133% return on your $3,000 investment. Had you funded the home purchase with more equity — a down payment of $20,000, say — your return would be much less, only 20%. ($4,000 is 20% of $20,000.)

(MORE: Mrs. Warren Goes to Washington: Does the Market Mistrust Big Banks?)

Debt, in other words, magnifies your performance, good or bad.

Of course, many people now feel that big banks don’t have to worry about bad performance being magnified because under the implicit “too-big-to-fail” guarantee of the government, they won’t have to take the losses when asset values decline. Last time it happened, after all, taxpayers picked up that tab. So for bankers, funding their operations with equity really is expensive — it would mean that the owners of the banks would have to foot the bill when things go south.

Yet that’s not the reason banks give for resisting calls to increase equity requirements. Instead, they claim that such requirements would impair their ability to compete and lend — and that claim carries a lot of weight because less lending would very likely translate to slower economic growth.

But would higher equity requirements really force banks to lend less, as the banks claim? Admati and Hellwig spend more than 300 pages arguing that it would not — and that this pretense is the banking industry’s biggest and most dangerous lie.

This debate gets a little technical, but follow me. Managers of big banks claim that they can’t fund themselves with more equity and still lend as much as they do now because stock holders require a higher rate of return than lenders do. (This is true.) And to produce this higher rate of return, bankers say, they would have to turn down many of the slightly-less-profitable lending opportunities that they are now able to make.

Admati and Hellwig counter that the only reason stockholders demand such a high rate of return from banks is to compensate for the relative riskiness of banks — and that they are risky precisely because of all the debt they hold on their balance sheets.

(MORE: What Can Be Done About Growing Inequality?)

Keep in mind, this isn’t just a theoretical argument. The recent Basel III pact, an international accord under which central banks across the world — including the U.S. Federal Reserve — agreed to regulatory standards, requires banks to increase their equity funding to at least 7% of their “risk-weighted” assets by 2019. And formulas that give certain types of debt different weight means that some banks would be allowed to have equity financing as low as 2% or 3%.

Admati and Hellwig argue that the Basel III requirement are far too low, and that the U.S. should unilaterally raise these equity requirements to between 20% and 30% of assets. The only reason we haven’t, they say, is that Wall Street has successfully convinced politicians and the public that if equity requirements are raised, it would hurt the economy. The authors’ proof that this is not the case? The rest of the modern financial economy. “If capital is expensive, as banker’s suggest, and borrowing is cheap, why doesn’t this apply to other corporations? Why don’t nonbanks borrow more and economize on their supposedly expensive equity?”

And the answer to that rhetorical question, of course, is that nonbank companies generally don’t get bailed out when the whole thing blows up.

My own take is that this question probably isn’t quite as cut and dry as the authors make it out to be. There are reasons to think that raising the requirements could restrain bank lending at the margins. But I agree with the authors that the warnings of the banking industry are greatly exaggerated. And it seems clear that slightly higher interest rates and slightly fewer loans are a small price to pay for a truly sound banking sector. After all, it was too much reckless lending that got us into this mess in the first place.

(MORE: A Heaping Helping of Chutzpah: AIG Considers Suing the U.S. Government For Bailing It Out)

11 comments
KrishNathan
KrishNathan

Banks are holding Governments hostage through out the world..too big to fail, too big to jail and the new untouchables have all become the new norm in the financial world..Governments by allowing unbridled expansion of banking are now at their mercy. Unwinding from this position would take guts and a courageous government to say no and allow a big institution to fail, taking down a few who had earlier benefited. If any poor, or middle-class are affected, they could be bailed out by the Governments, instead of the banks. A bit of manufactured down-sizing of banks is good for the world economy...But will it happen soon ? Don't hold your breath.

Galen
Galen

The word bluffing is total BS! They are lying.

TimothyRatliffe
TimothyRatliffe

@Dewey. Your  good comments are noted. As far as I can see the US does not have a Head of State, and neither does it have a Head of Government. England, for example, has both. I see no provision in the Constitution for either. Having said that, it really does not matter. The system is what it is, and we have to make it work.

DeweySayenoff
DeweySayenoff

The problem that I see are "stock holders".  This runs through the entire business world as well.  Stock holders take the focus of the business OFF the customers and put it on short-term profits.  Now, it may be rather radical to say that stock holders should accept the fact that investing is a risk/benefit behavior.  They seem to be looking at it strictly as a benefit behavior.  They ignore the fact that it inherently entails risk.

But just the fact that a person has "invested" in a company takes the focus of that company off the customers.  The ability to work the business without any considerations other than the customer is disrupted by considerations for those who have put money into it.  Some of the customers may be investors, but that's not always the case and it's still a splitting of attention.  The result?  Inferior products, a loss of innovation and "safe" business decisions all of which mean less for the customer and more for the investors which negatively impacts the business over the long run.

A good - if extreme - example is Apple.  Their stock rose hugely pushed along by Job's cult of personality and marketing genius.  "Innovative" products helped bring in investors who began to expect the kind of performance Apple was delivering.  But Jobs died, and Apple's "innovation" came to a screeching halt.  It was always marketing, of course, but that's beside the point.  Once the perception of innovation ended, the stock values dropped - a lot - and the stock holders started clamoring for change and a return to the gravy train days.  Apple has yet to recover its losses and can't spin (or market) the problems they've had as well as Jobs did. 

But the bottom line is that they seem to be focusing on making "safe" business decisions.  Releasing the iMLost map app before it was ready was something Jobs would never have done.  He would have taken the risk of losing a relatively small amount of revenue to Google for the time it took to get the iMap app to be done RIGHT.  The "safe" business decision was to generate as much short-term revenue as possible to placate the stock holders.  In making the "safe" business decision to keep the stock holders happy, and taking the focus off of the (usually quite fanatic) customers, Apple shot themselves in the foot and lost serious credibility.  The revenue they lost due to this "safe" business decision was far and away more than what they would have lost had they simply waited for the Apple Maps app to be finished and done right.

All because of a focus on stock holders wants and needs at the expense of customers.

With regard to banks, the same thing happened.  They catered to the investors, wrapping up extremely risky sub-prime mortgages to hedge their anticipated losses (let's face it, you expect sub-prime mortgages to have a far higher-than-average default rate) and it blew up in everyone's face when the housing market tanked.  Those investments were catering to the stock holders rather than making sure the home buyer could actually afford to repay the loan - a duty to both the business and the customer.

I know stocks are a way to finance businesses to expand operations and such, but I think it should be done in an entirely different way.  The focus has to stay on the business and the customers. That focus doesn't seem to be bothered by traditional business loans, so perhaps investors could be set up as creditors who get back a fixed amount over a particular term.  This reduces their returns, obviously, but also reduces their risk, and keeps them out of the boardroom.  If they don't like the way the company is run, they can't do anything about it - even if the business defaults on the loan.  All they can do is collect the money through bankruptcy proceedings (assuming they can get their money back - as creditors, they may not be able to).

It would re-shape the financial world, of course, but it would keep money circulating in the economy.  The problem today is that investors tend to reinvest their money, which means it's not being spent.  Spending is what drives an economy.  I won't go into that rant, but the more investors suck out of businesses, the less money is circulating.  If businesses don't have investors to worry about, they'll be more apt to simply pay off loans and use the extra money (business has a lot of money right now!) to upgrade, streamline, maybe even hire more people.  They'd SPEND it - which puts it into circulation and helps stimulate the economy.  When money pools and isn't circulating - accumulation of wealth in investments or in businesses - the economy suffers.  Stockholders are part of the reason the economy is so sluggish.  Just apply the basic bottom-up spending rule to increase demand which encourages new job creation to the idea and it makes economic sense.

It remains to be seen whether anyone will do anything about it.  Given the way the economy is run, I rather doubt it.

ronajrny
ronajrny

To my simple mind, the first and most certain  way to begin to resolve this organized criminal activity is to arrest, prosecute and jail the perps to the full extent of the law. Let the CEO's go to prison just like every other citizen is in danger of doing when they break the law. The arrogance and greed has to be met with the righteousness of the taxpayer who is getting robbed blind, and supported by the laws of our democracy, bar none. This should start with the CEO of JP Morgan Chase and his minions and not stop until everyone guilty of massaging the numbers or providing misleading information is brought before a judge and jury of their peers.

MarcusTaylor
MarcusTaylor

Bill Black, a former Bank Regulator and the man that exposed the Reagan Savings & Loan fiasco, the crisis that happened on another "Republican" watch, noted that during the G.W. Bush Jr. Administration, the largest incidence of bank perpetrated white collar crime in the history of the world was publicly reported as an "epidemic" by the FBI in 2004 and in 2008 these same criminals "ran the table" on the American economy (500 white collar crime investigating FBI agents were pulled off the case by the Bush Administration).  Yet the Republicans and Tea Party faithful continue to say NO to regulatory reform.  My answer ... Elizabeth Warren for President!

Propaganda is the only way you can get people to promote a cause that actually does harm to the promoter.  But as my Colonel said . . ."never discount  stupidity".

tom.litton
tom.litton

Instead of punishing the banks, why not punish the people running the banks?  

For example, if a bank needs to be bailed out, then garnish the wages (or other earnings) of the top 5 compensated executives at the time the bank become insolvent until the loan is payed back.


Galen
Galen

@TimothyRatliffe 

Head of this or that matters little. It has absolutely nothing to do with anything. If these so called heads do nothing or make huge mistakes, what the hell diff does it make what you call them... please.

TimothyRatliffe
TimothyRatliffe

The US constitution says nothing about leadership. Obama is the head of the Executive Branch, nothing more. He is not king; he is not Head of State. Free men do not need a leader. They have the law. The US is a nation of laws, not of men. There are two other separate, co-equal branches of government. They operate independent of each other, and they do not need the President's permission to do their jobs.

DeweySayenoff
DeweySayenoff

@TimothyRatliffe Not to pick too much of a fight, but ANY President of the United States is, in fact, the head of state.

A head of state isn't necessarily a monarch or dictator.  It's the "leader" of the country.

Furthermore, the U.S. is not a nation of laws.  It is a nation of men who democratically decide by what rules they will abide.  We have the right to change those rules because time and history have proven that laws can be flawed.  A nation of laws can't change those laws.  A nation of men who decide what the laws will be can.

Free men - at least in the United States - have a leader whether they want one or not.  Your implied description of "free men" is the perfect definition of an anarchist - one who acts only by their own judgement.  The notion that the laws dictate the action of "free men" is equally false because if a "free man" didn't agree with the law, they would break it because he believes he has the freedom to do that.

Laws exist to tell the rest of society where the limits of "free behavior" lie.  A "free man" doesn't accept limits on his "freedom" - especially when they don't agree with a particular law.

As for the rest, yes, we have a balance between the executive, legislative and judicial powers of the government with each handling a part of the responsibility of running the government.  This was done to ensure that no single branch wields power over the others.

So in the end, the President DOES lead, because that's what the executive branch does.  It presents the budget.  It directs foreign policy. It enables executive rules within its scope of power.  It decides on who will head various cabinets and departments, all organized within the executive branch of government.

As for the originator of this little thread, it's obvious he has no idea what leadership means or entails.  Obama is doing what every President does.  The running of a government in a country as large as ours can't do it all himself.  Sneering at him "delegating" things means you're sneering at every U.S. president since the guy who sat in the chair waiting for George Washington to show up.  Delegation is the essence of leadership by picking those who are best for the job they're assigned to do.  But every President takes the heat for what their underlings do as well as the credit.  Every president has also taken the credit for what their underlings do as well.  Remember GWB'S "Mission Accomplished!" signs?  He had the option of asking them to be taken them down or making sure they didn't appear on camera with him.  He chose neither and let the implication go out that the job was done and done well.  Of course, it back-fired on him when the war dragged on and was far from "accomplished", and he tried to spin that several ways.   He also took credit for every good thing that happened and tried to deflect blame for the bad things.

What's sauce for the goose is sauce for the gander.  Behavior that you don't accept in one person can't be acceptable in another.  If you don't like these things in a person, you don't like any politician (except, possibly, Trueman who actually accepted responsibility with his "buck stops here" motto) or any corporate leader.  They all do it.  But in the end, they all eventually have to accept the color in which history paints them.  So by your lights, no President has been a person of character or principles in the history of the United States.  But I also suspect that if placed in the position a President is placed in, you'd find your own "character and principles" going out the window faster than a Gauss round leaving a rail gun when faced with the realities of what it takes to run a country.  If not, you'd be the most incompetent President in U.S. history.