Book: Wall Street’s Biggest (and Most Dangerous) Untruth

Stock Markets Take Drastic Downward Slide

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 reformsthat 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.”)

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.)

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.

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.

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