More equity, less risk
How can we make banking safe? A head of steam has been building behind the idea of restructuring banks so that their retail arms are cushioned from riskier activities, and can be plucked neatly from the clammy grasp of any future floundering bank. That is sensible – if easier said than done.
But why leave it there? The simplest way to reduce the risk of a future banking crisis is to force banks to hold more equity.
More equity makes banks safer, other things being equal, because the shareholders who provide the equity have no claim to being paid any particular sum of money. They simply get whatever is left after the bank takes its profits and its losses. That flexibility is what provides room for mistakes – essential in any complex system.
The Basel III accord, unveiled last autumn by banking regulators, was a big step forward in requiring banks to hold more equity. But David Miles of the Bank of England argues that banks should go much further, and recently Tim Geithner, the US treasury secretary, and particularly Daniel Tarullo of the Federal Reserve, have done the same. They are right to do so.
After the crisis, it might seem obvious that Miles, Geithner and Tarullo are right. Why might they not be?
The banks themselves point out that equity is expensive: shareholders demand high returns because they are taking high risks. These returns were previously delivered by keeping the capital cushion as thin as possible: as money from a bank’s investments flowed in, much of it would be paid out to the bank’s creditors. The modest amount left over would still be enough to provide rich rewards to shareholders because equity was so small compared to the scale of the banking operations.
But with much more shareholder equity, the banks claim, there won’t be enough money to compensate shareholders for taking risks. Fewer loans will have to be made, and at higher interest rates. Small businesses and would-be housebuyers will suffer. This is plausible, widely repeated, and nonsense.
Forcing banks to fund themselves more through equity than debt makes shareholders safer, unless they were always safe because of a government guarantee – exactly the situation we wish to abolish. This safety reduces the return shareholders require. If shareholders really want to combine high returns with a high risk of being wiped out, they can always borrow money themselves and use the borrowed money to buy shares in banks. There is no reason that the banks themselves, the basic infrastructure of the world economy, should be allowed to make themselves fragile in order to deliver these returns.
All this is obvious in theory – the theory being the famous Modigliani-Miller theorem, which shows that under certain conditions whether a company is funded by debt or equity makes no difference – but it also seems to be borne out in practice. Miles and his colleagues have produced empirical research showing there seems to be no strong relationship between fat equity cushions and anaemic bank lending.
More equity would not solve every problem in the banking system. For instance, Basel III retains the problematic “risk weighting” concept of Basel II, in which banks can hold less equity if their assets are very safe. Historically, safe assets have included Greek government bonds and mortgage-backed securities. It is easy to see the flaw in this rule, and since there is little cost to funding banking through equity rather than debt, it is hard to see the point of it.
There can be no panacea for banking regulators. No rule change will be without its unintended consequences in such a complex system. But insisting on more equity – much more – is something banking regulators must find the courage to do.
Also published at ft.com.
4 Comments
Dave Diamond says:
Isn’t there a place in our financial system for risky institutions? What if you called them something else, like venture funds, with their own system of regulations?
2nd of July, 2011Jared says:
I don’t agree with calling the “risk weighting” concept “problematic”. Two reasons for this: Firstly, a large component of Basel risk weighting is driven by credit worthiness. Basel only begins to derive the credit risk of a Counter-party after they have been deemed credit-worthy by the Bank. Bank’s short-shortsightedness in granting loans has now been revised post recession. The risk weighting was not a failure of Basel but rather of Banks’ inadequate credit lending controls – Basel assumes these are executed correctly. Secondly, Once an asset truly does become risky, Basel will fully compensate for that risk. Case in point, Banks are now required to hold significant capital on Mortgages. My conclusion, we cant just arbitrarily say “banks need to hold more equity”; Banks must hold equity according to the risk within the bank. Arbitrary demands to increase capital could unleash a further (more damaging) recession.
4th of July, 2011James says:
I’d be interested to hear an expert opinion on Dambisa Moyo’s book “How the West was Lost”. Moyo says something similar to what Tim said here, but in reverse: it is pointless to try to regulate shareholder risk, Moyo says, because risk is what equity investors seek and get paid for. If they didn’t want risk they would buy bonds instead. Government should stick to regulating transparency.
In this quest for risk and return, Moyo goes on, equity seeks ever more leverage. It’s for credit markets to regulate risk by analyzing and rating borrowers and deciding when enough’s enough. But wait … at some point governments started relieving credit capital of that responsibility, regulating credit risk on its behalf, and underwriting it with moral hazard and with democratic conflicts of interest.
If Dambisa Moyo’s right, the Basel Accords are part of the problem, not part of the solution, and Greece should give credit lenders and regulators a wake-up call by defaulting.
I’m a layman, so perhaps the fact that it makes sense to me is a warning sign that it’s too simple. I haven’t read any good reviews of Moyo’s book; they all get bogged down nitpicking errors in the examples without getting to the nub of her argument. Have you read it, Tim? I’d like to hear what you think.
TH: No, James – haven’t read it yet. Sorry…
13th of July, 2011Roald says:
The Spanish economist, Jesus Huerta de Soto, argues that ever since te 1848 Peel Act, banks have had the legislative backing to create credit (= money) out of thin air. For every 10 pounds deposit, they could create 100 pounds of new credit. To sustain this scheme, which leads to the economic business cycle, you need to cover banks (especially big banks) by Central Bank and/or government support, when the boom goes to bust. In medieval times, goldsmiths would also give out more “I owe yous” than the gold they had in stock. This was rightly considered fraud. Now, however, banksters and modern policians have us convinced that this is good business practices, because credit makes the economy going. Of course Austrians would point out that real savings need to come before real investment. If not, you just create credit bubbles and inevitable busts. So yes, MUCH higher equity ratios are required. We need to end the whole scheme of central banking and fractionary reserve banking. Regulation has brought us here, free markets would never sustain highly indebted banks, without the explicit goverrnment guarantees which work as a huge Moral Hazard.
17th of July, 2011