Time for banking’s petulant toddlers to grow up

30th August, 2013

Like monstrous toddlers, the world’s banks have stumbled from manic exuberance, destroying all they touch with clumsy glee, to petulant refusal to get up off the floor. As any parent will tell you, round-the-clock supervision of toddlers is impossible and clearing up the crap is no fun. How can we force banking to grow up?
The fundamental problem is that governments – rightly, given the present set-up – regard certain banks as too big or too interconnected to fail. In the last resort, they must be rescued lest the financial system as a whole be destroyed.
From that single flaw springs all our troubles. Banks find it cheap to raise money as debt, rather than as equity. That makes banks fragile: any highly-leveraged company flirts with bankruptcy. In a more respectable industry (such as pornography or tobacco) that risk would encourage use of equity, a more resilient source of funds. But with the government acting as backstop, who cares?
Regulators, then, are forced to craft rules to oblige banks to use enough equity capital. These rules do not work. Complex risk-weighted systems have failed utterly: again and again, banks have failed despite meeting regulatory requirements. With hindsight, simpler rules gave better warning of banks in trouble, as the Bank of England’s Andrew Haldane pointed out in “The Dog and the Frisbee”. (This is the closest thing central banking has to a speech with a cult following.) But simpler rules would soon be exploited.
There’s much to be said for the idea that banks should just be forced to rely much more on equity than they do today. But while the costs of using equity in place of debt are often grossly exaggerated, they are not zero. And even with a large equity capital cushion, the perverse incentives of “too big to fail” will assert themselves: bankers will find new ways to snuggle up with bankruptcy.
Fragility isn’t the only problem here. Banking is pro-cyclical, fuelling every boom and deepening every slump. When times are good, banks are machines for sucking up cheap money and spraying it all over the place. Conversely, stressed banks find it hard to raise the capital they need, because new equity investors know they would stand behind debt holders in the queue to be repaid. Unable to raise equity, banks are reluctant to lend.
Once you have ruled out the unacceptable, whatever remains, no matter how odd, must be accepted. We need to return to a market-based system of banking regulation – one in which banks can be allowed to fail. In a market-based system, banks would need to reassure their backers that they were acting like grown-ups – a process likely to be more subtle and robust than ticking regulatory boxes.
The appeal of this is obvious. But the problem has always been that nobody believes a regulator could allow a big bank to fail, and so market discipline fails. But perhaps there is a way out, by changing the way that bank debt works. A new debt contract, the “equity recourse note” (ERN), is at the heart of a proposal by market veteran Jacob Goldfield and two economists, Jeremy Bulow and Paul Klemperer.
An equity recourse note would work like a traditional bond, except that at times of stress, the interest payments would be made in equity rather than cash. “Stress” is defined not by regulators, who might hold back for fear of causing alarm, but by the bank’s share price.
Let’s say the share price is $40 when the ERN is issued. The trigger price could be one quarter of that, or $10. At any point when payments were due but the share price was below $10, the payment would be made in shares instead, at a nominal price of $10. A $10,000 interest payment would instead be 1000 shares.
Now adopt a simple rule: all unsecured bank debt must be in the form of ERNs. (Depositors would be treated separately.) What then?
Banks do not “fail”. They can’t go bankrupt because it is always possible to issue new equity and satisfy the terms of the ERN contract. Stressed banks automatically acquire thicker equity capital cushions.
The process is gradual. There is no traumatic moment at which large chunks of debt convert to equity, possibly causing trouble elsewhere in the financial system. Payments only convert to equity when they come due, and not every ERN will convert at the same trigger price. If a bank’s shares recover, subsequent interest or principal payments will be made in cash again.
Mismanaged banks will not collapse, but will be slowly starved of funds by disgruntled investors. “Too big to fail” banks become small enough to drown in the bathtub – apologies to Grover Norquist.
Finally, banking becomes counter-cyclical. This is because of the way the ERN trigger price is tied to the current share price. Even a highly stressed bank can raise new funds to lend out by approaching ERN investors: the new tranche of ERN would have a very low trigger price and so it would be senior debt, at the front of the queue for cash repayments. Conversely, a bank with highly-priced shares might find ERN investors hesitate – their ERNs would have a high trigger price, and would be at the back of the queue for repayment if the bubble burst.
Of course, investors would prefer to receive cash, not shares, and for this reason bankers would have to work hard to prove their honesty and competence. All this sounds refreshingly like grown-up market forces in action. Banking regulators should give it a try.

This column was first published, in abbreviated form, in the Financial Times.

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