As we near the three-year anniversary of President Obama signing the Dodd-Frank financial reform bill into law, the too-big-to-fail banks that percipitated the crisis are bigger and more powerful than ever. Though the new legislation does arm regulators with more powers that may prevent a large financial institution’s failure from bringing down the broader economy, experts warn these tools are untested, and that the feds may have to resort to bailing out banks again if we suffer a repeat of 2008.
That’s why yesterday federal regulators put forward a proposal that goes beyond Dodd-Frank regulation, as well as the global agreement on minimum banking standards known as Basel III, by asking large banks with more than $700 billion in assets to increase the percentage of their businesses that are funded with equity as opposed to debt.
So why is equity funding so important? It’s useful to think about it in terms of a homeownership: Imagine that the government required everyone to fund home purchases with at least 20% equity, which for a long time was an industry standard. To buy a $100,000 home, for example, you’d need to spend $20,000 of your own cash, and you’d be allowed to borrow the other $80,000. That way if the value of your home falls by a few thousand dollars, you’d still have a substantial ownership stake in the home — or, to put it another way, unlike some 10 million U.S. homeowners at the moment, your home wouldn’t be “underwater.”
The same principle applies to businesses: They can either fund their operations by borrowing, or convince investors to provide “equity” funding in return for an ownership stake in the firm. Debt is particularly attractive to financiers, however, because it dramatically enhances profit potential on the upside. Let’s go back to the home analogy: If your house, which you purchased with $20,000 in cash and $80,000 in debt, increases in value by, say, 5%, you’ve made a tidy 25% profit on your investment. But if you had put down only $5,000 and borrowed $95,000, your profit would be 100% — just like that, you doubled your money.
Many businesses fund themselves entirely through equity, but banks tend to fund themselves mostly with debt. The reason, as economists Anat Admati and Martin Helwig explained in their recent book The Bankers’ New Clothes, is that government safety nets blunt the riskiness of debt financing. Explicit government guarantees like deposit insurance, and implicit guarantees like the financial-crisis bailouts have nearly eliminated the downside of bank borrowing. Lenders do not charge thinly capitalized banks a premium for their risky funding structures because they believe the government will step in if anything goes awry.
Since the 2008 financial crisis, the government has made credible steps towards setting up a system where those bank bailouts won’t be necessary, but we won’t be sure whether those reforms work until the next crisis. Therefore, lawmakers like Senators Sherrod Brown and David Vitter have argued that we should simply require banks to fund themselves with more equity. The proposal by federal regulators to increase this funding requirement to up to 6% doesn’t go as far as Brown and Vitter would like, but it surely is a step in the right direction.
Industry representatives said the proposal could hurt the broader economy by requiring banks to hold more cash in their coffers to meet regulators’ demands rather than making loans. The largest banks already have moved to shore up their capital in the wake of the financial crisis.
“Ever-higher capital requirements, while a critically important element of safety and soundness, can become prohibitive and actually lead to reduced capability to lend,” said Rob Nichols, president of the Financial Services Forum, which represents the chief executives of the nation’s largest financial firms.
But as Admati and Helwig point out in their book, this line of argument is without much basis in reality. The 6% equity-funding requirement put forth by regulators is far below the 20% to 30% they argue for, and large banks could easily attain this level of capital by simply holding on to their profits rather than returning them to shareholders in the form of buybacks or dividends. This will lead to lower stock prices in the short-term, but won’t prevent banks from making sound and profitable loans.