What a difference a couple of years and trillions of dollars in taxpayer money makes. In the fall of 2008 the worry was that ATMs would go dark and the financial system would collapse, taking civilization with it. Treasury Secretary Hank Paulson and Fed Chair Ben Bernanke panicked, and we’re told we should be very glad things turned out the way they did. Time magazine was so glad it made Bernanke its 2009 Person of the Year.
Since those dark days, the banks have rebuilt themselves, their profits, and their bonuses. Meanwhile Chris Dodd and Barney Frank passed landmark legislation to make it safe to go to your bank again. The international banking regulators are cooking up new rules known as Basel III that will supposedly keep us from reliving 2008.
Economists Anat Admati and Martin Hellwig would beg to differ. The new regulations do nothing to make banks safer. The authors spell out what will make banks safer and sounder in their new book The Banker’s New Clothes: What’s Wrong with Banking and What to Do About It. The tonic they prescribe? More capital.
What most people—even bankers themselves—don’t realize is that modern banking is a highly leveraged business, to the point of being dangerous. How many entrepreneurs have gone into a bank looking for a loan to fund their business, only to be told they were already too highly leveraged? Plenty. Talk about the pot calling the kettle black. But bankers always come across like their operations are all so safe and sound. For instance, bankers never discourage someone from making a large deposit by telling the customer, “No thanks, we’re very highly leveraged already.”
Admati and Hellwig walk banking neophytes slowly through how banking works, framing examples in a way that most people can understand: borrowing on a home. In very simple terms the authors explain how excess leverage is dangerous. Ironically, bankers are quick to point this out when examining someone else’s credit prospects but not necessarily their own.
Banks are always treated as special business cases and the authors don’t see why. If Apple and Bed, Bath and Beyond can do business successfully without borrowing, why can’t banks? Even European corporations, which borrow more than their American counterparts, still maintain 30 percent equity. Meanwhile, most banks have less than 10 percent equity and many have less than 5 percent.
Being leveraged 20-1 means, for the bank to survive, that very little can go wrong. If a bank’s assets are mostly mortgage loans at 80 percent loan to value, and property values drop 25 percent, that 5 percent equity is gone. Nationwide, housing values crashed more than 25 percent in 2008 and 2009. In cities like Las Vegas, values plunged by more than 50 percent.
It wasn’t always this way. Bank owners once had direct personal liability to the bank’s creditors (including depositors). In those days, equity levels of 40–50 percent were the norm.
Since the 1930s, limited liability and government deposit insurance have done away with the need for that sort of conservatism.
Government can claim all it wants that it is regulating away a repeat of the 2008 crash, but the fact remains that using high leverage is alive and well, as are limited liability and higher levels of deposit insurance.
With government covering the deposit liabilities, banks have over time had more incentive not only to overborrow, but to borrow short term and to lend on assets that are illiquid and long term. This mismatch between asset and liability durations magnifies risk and causes liquidity problems, making banks increasingly dependent on the lender of last resort—the central bank. In the case of 2007–2009, the authors point out that with financial institutions funded with short-term debt owed to each other, atop but tiny slivers of equity, the tripping of one domino set off a contagion. The modern banking world is all interconnected.
Layer on top of all of this leverage new financial products like derivatives and the potential for gambling and speculation runs rampant. Derivatives can be a great financial tool to diversify risk. However, as Admati and Hellwig make clear, derivatives also magnify risks in the same way that leverage does.
The fourth quarter 2012 FDIC Quarterly Banking Profile reports that FDIC-insured institutions held $224 trillion in derivatives at year end. Fifteen years ago that amount was a mere $25 trillion.
For the most part this massive derivatives exposure does not appear on bank balance sheets. In an eye-opening part of the book, the authors point out that J.P. Morgan Chase & Co.’s “fortress balance sheet” does not look so sturdy using international accounting rules rather than the U.S. variety. J.P. Morgan had 8 percent equity on its December 31, 2011, balance sheet under U.S. rules. However, using international accounting rules, which count more of the bank’s derivative exposure, the equity falls to 4.5 percent.
The authors remind us that Bear Stearns was considered a strong bank in 2006, 18 months before it was picked up in distress by J.P. Morgan Chase. In the next contagion, with equity of only less than 5 percent, J.P. Morgan Chase itself could encounter the same fate.
More equity would cure many of these ills, but bankers constantly bellyache that equity costs too much. Equity investors require a higher return than debt investors do. Hellwig and Admati rightly wonder: if equity financing is so expensive, why do other firms in other industries use it so much? Banking, as an industry, is alone in operating with such tiny bits of equity and huge debt.
Banking is also alone in having some of the costs of being highly leveraged borne by the government through guarantees and central bank subsidies. These distortions make equity relatively more expensive than debt, leading banks to leverage up and become more dangerous.
The authors explain the flawed thinking that equity is too expensive. In a world without government interference, the more debt used, the more risk is associated with the equity, so investors demand a higher rate of return. Conversely, the less debt used, the lower the rate of return required by the equity holders, because the default risk is lower. But the government turns this logic upside down by having taxpayers absorb much of the risk of bank leverage.
Admati and Hellwig urge governments to force banks to maintain more equity. But perhaps the force that keeps banks operating should be simply taken away. Bring back the bank run and let the chips fall where they may. With no insurance and no too-big-to-fail policy, depositors would choose more wisely. Money would flow to the prudent. Banks would maintain more capital as a matter of survival instead of levering up to lend on the latest investment fad.