By Anat Admati, Professor of Finance and Economics at Stanford Graduate School of Business. To see her explain these issues in person, watch this Bloomberg interview. This is a long post, about 3,500 words.
The debate is raging about banks and their size, financial regulation, and the international capital standards known as “Basel”. Jamie Dimon of JP Morgan Chase, in his New York Times magazine profile, expresses admiration for the Basel committee and says,
“… they are asking the questions that, in theory, bankers ask of themselves: how much capital do banks need to withstand the inevitable downturn, and what is an acceptable level of risk?”
There is one problem, however. Basel may have asked the right question, but it did not come up with the right answers, mainly because it allows banks to remain dangerously leveraged, setting equity requirements way too low. This fact is not understood because the debate on capital regulation has been mired with a cloud of confusion, and filled with un-substantiated assertions by bankers and others. As a result, the issues appear much more mysterious and complicated than they actually are.
After a massive and incredibly costly financial crisis, we seem to have financial system that is a more consolidated, more powerful, more profitable and, yes, as fragile and dangerous as we had before the crisis. How did this happen and what can we do?
Here are some questions on which the confusion is staggering.
(i) Is “too big” the same as “too big to fail?”
(ii) Do capital requirements force banks to “set capital aside for a rainy day” and not use it to help the economy grow?
(iii) Are banks different than non-banks in that high leverage is essential to banks’ ability to function?
(iv) Would terrible things happen if capital requirements were to increase dramatically?
The first order of business is to clear the fog and focus on the right things. I will try to explain. With the basics in place, answers will begin to emerge, or at least the right questions to ask.
By the way, I answer an emphatic NO to each of the above questions.
Let’s start with balance sheets
Take a bank; indeed take any firm. The balance sheet is a snapshot of assets and liabilities. It has two sides, often shown piled on top of one another in financial statements or online data.
On the left hand side, or the top, of the balance sheet are the firm’s assets, what the firm owns. The numbers come either in the oxymoron called “book value” that accountants produce based on historical costs, or in the more meaningful “market value,” which for illiquid assets might not be readily available, and which can change frequently. More typically, some assets appear at cost and some are “marked to market.”
On the right hand side, or the bottom, of a balance sheet are the liabilities and “shareholder equity,” a summary of the claims that are held by various parties “against” the assets. There are two basic types of claims here: one called broadly “debt” (or “liabilities”) and the other is “equity.”
There is a huge variety of debt claims. One that we all provide to banks is called “demand deposits.” Depositors can demand that this debt is paid back at any time. Other debt claims are distinguished by the length of the commitment, the interest rate, the collateral and the “seniority” (the place in the creditors’ queue in a bankruptcy) and other provisions. Depositors are the most senior creditors of a bank; junior, unsecured debt-holders, or holders of certain “hybrid” securities, are the last in this priority line. If a bankruptcy occurs, however, it can take years to sort all these different debt claims out.
One feature of corporate debt is that the tax code allows interest paid on debt to be called a business expense and it is deductible before corporate taxes are calculated. This is similar to the deductibility of mortgage interest payments for homeowners.
But the main feature of debt that distinguishes all debt claims from equity, is that debt is a hard claim, an “I Owe You.” Creditors have rights to take legal action if they are not paid what they are owed. They can cause a financial failure or bankruptcy. This process can be a terrible thing or not so terrible. Airlines “fail” routinely and they renegotiate some contracts, re-organize, and emerge out of bankruptcy. No stigma is attached, and operations often continue, although of course it is bad news. And debt contracts work well when the bank finances individuals and businesses. Things are different, and much more problematic, when banks use a lot of debt to fund themselves. More on this later.
The final part of the balance sheet is the category of “equity.” Bankers like to call it “capital,” but let’s stick to the standard terminology of equity. (Using a different lingo than for other types of firms is part of the mystique of banking and helps in creating confusion.)
There are a few distinctions within equity too, mostly between “preferred” and “common” equity. Preferred equity, like debt, specifies how much the holder of the preferred will be paid. The lowest-class equity, called “common equity” cannot be paid at all until the preferred equity is paid what it was “promised.” The key difference with debt, however, is that the firm does not “fail” if it does not pay its equity holders, even if they are “preferred.”
Why does anyone buy this bottom-feeding equity? Because equity gets the upside, the profits of the firm, and if the firm is successful –and banks make a lot of money most of the time — this can be a very good deal. For banks, in fact, the return on equity is very high, often in the order of 25%. This is not something “abnormal.” It is likely the “appropriate” return, because this “leveraged” equity is also quite risky. In financial markets, the higher the risk, the higher the average or required return.
Leverage and funding costs: the basics
Financial leverage is about how much debt relative to equity a firm has. The more debt relative to equity, the higher is the leverage. Does it matter to overall funding costs how much debt vs equity a firm uses? There was a great deal of confusion about this way back in the first half of the 20th century. In 1958, two economists, Franco Modigliani and Merton Miller (who separately won Nobel prizes, partly for this work) considered this issue and showed that, while leverage does typically affect overall funding costs, this is not due to the reasons people were giving at the time, which were based mostly on the fact that equity has a higher required return than debt.
The so-called MM result from 1958 builds on a basic “conservation of value” principle. As leverage changes, so does the riskiness of equity (and sometimes that of debt as well), and thus its required return. If there were no other factors, such as third parties (think governments) taking or injecting cash in taxes or subsidies, and if the funding method did not affect the investment decisions of the firm that determine what is on the assets’ side of the balance sheet, then it would be irrelevant how much debt vs. equity is on the balance sheet. Of course, none of these “ifs” are true in reality, particularly for banks, so capital structure does matter, sometimes a lot.
