In their recently published book, 'The Banker's New
Clothes', Anat Admati and Martin Hellwig make a strong case that in
order to reduce the risk of insolvency in major financial institutions, shareholders
should be required to fund their lending and other investments to a much
greater extent.
The authors argue that government regulation to reduce the
risk of insolvency of major financial firms is desirable because failure of
such firms has adverse effects that are analogous to those that can arise from accidents
in nuclear power plants. When I discussed that analogy in an earlier post, I
accepted (somewhat reluctantly) that it is appropriate. As a result of the
interconnectedness of financial markets, it would probably not be possible to avoid
major economic disruption if large financial institutions were allowed to fail
when they became insolvent. That makes it desirable to find the least cost
way of regulating them to make it less likely that they will become insolvent.
Governments are thus presented with problems that are similar to those involved
in regulating the nuclear power industry to reduce the risk that serious
nuclear accidents will occur.
Admati and Hellwig suggest that the best way to reduce the
risk of insolvency of major financial institutions is to require them to raise
shareholder equity from current levels (which under Basel III can apparently still
be as low as 3 percent of total assets) to 20-30 percent of total assets. The
higher ratio of shareholder equity to total bank assets would provide greater
scope for any future fall in the value of bank assets to be accommodated
without insolvency.
The authors suggest that requiring banks to rely more on
equity funding would impose little, if any, cost to society. In this post I
want to focus specifically on the reasons they give for that view. I encourage
readers who are interested in a broader discussion of this important book to
read John Cochrane's review.
The authors argue that requiring banks to rely more on
equity funding would impose little cost on society because it would offset the bias
in favour of borrowing provided by government guarantees and tax systems. Banks
and their creditors benefit from explicit guarantees to protect depositors as
well as implicit guarantees associated with the 'too big to fail' concept.
These guarantees enable banks to borrow on more favourable terms than would otherwise
be possible. Tax systems tend to favour borrowing because they make interest
paid a tax deductible expense. (The
dividend imputation system in Australia reduces this bias to some extent but,
as acknowledged by the Henry Tax Review, there is still a bias in favour of
foreign borrowing and Australian banks rely heavily on this source of funds.)
The authors point out that equity ratios of banks were generally
much higher in the 19th century, prior to the existence of
government guarantees. In the US, until
the middle of the 19th century, equity levels around 40-50 percent
of banks' total assets were typical and early in the 20th century it
was still common for banks to have equity of around 25 percent. The picture
seems to have been broadly similar in Australia. Data presented in an article
by Charles Hickson and John Turner shows (apparently) that the average equity
to deposit ratio of Australian banks declined from around 60 percent in the 1860s
to around 20 percent in 1892. The subsequent depression would presumably have substantially
depleted the equity of those banks that managed to remain in business. Adam
Creighton, a journalist, implies that the surviving banks re-built their
capital ratios following the depression, so that a century ago they maintained
capital ratios of between 15 per cent and 20 per cent. (See: 'Time to Force the Big Banks to Hold More Capital', 'The Australian',
23 November, 2012.)
Admati and Hellwig point out that the proposed increase in
bank equity would not interfere with core banking functions of accepting
deposits and making loans. Given the current structure of balance sheets, the increase
in equity levels would tend to displace additional borrowing from sources such
as money market funds rather than bank deposits.
The authors point out that bankers' claims that equity is
more costly than debt are flawed because they don't take account of the effect
of increased equity in reducing the risk of bank failure and thus reducing the
rate of return required by shareholders. Equity only seems costly because
government guarantees provide an implicit subsidy on debt. The increase in
equity could be accomplished without significantly disadvantaging existing
shareholders by requiring banks to retain earnings rather than pay dividends, until
equity levels have reached the minimum level.
I am normally sceptical of claims that governments can
improve matters when they attempt to offset the adverse effects of previous
interventions by adding a further layer of regulation. It seems, however, that Anat
Admati and Martin Hellwig have found an instance where the theory of second best provides a valid guide to policy action. There are strong grounds
to argue that if governments cannot credibly bring the 'too big to fail' policy
to an end, they should take decisive action to offset the effects that policy
has had in encouraging banks to become more fragile. In my view the authors' proposals deserve
strong support.