The authors’ principal claim is that, to make the financial system safer, banks should hold more equity. Not only a little bit more, but much more equity!
Here are the principal topics of the book:
Instead of borrowing, banks should raise more equity!
What exactly means more equity in the authors’ opinion? First, it means equity as compared to total assets, and not to risk-weighted assets. Second, it means not around 5 % as is often the case today but between 20 and 30 % as we usually see in corporates. Traditionally, banks were even organized as partnerships and, until the middle of the 19th century, they often held around 40 to 50 % equity.
“In the case of banks, in fact, requiring more equity produces large benefits at virtually no cost to society.”
In addition, equity should only relate to what it really is – money invested by shareholders who accept to receive exclusively dividends, if they are paid at all. The authors advise against banks issuing other financial instruments that are only convertible into equity such as Cocos (= contingent convertible bonds = long-term bonds that can be converted to equity when some trigger event occurs).
Will more bank equity diminish lending to the real economy?
Bankers say that a higher portion of equity would lead to less lending to the real economy. The authors write that this claim is wrong:
Capital (in the sense of equity) is not the same as reserve requirements; it is not something that the bank “sets aside” or “withholds”. Capital is simply a source of financing that can fund lending to the real economy.
Bankers reason as follows: Equity is more expensive than debt. Therefore, financing the real economy through equity is more expensive than financing it through debt. This is not true, say Anat Admati and Martin Hellwig: If a bank has more equity on its balance sheet, the expected return of shareholders will be lower and, thus, the price of the bank’s equity. As a result, a change of the debt / equity mix does not change the cost of funding for a bank. It only changes the distribution of risk and return among shareholders and debt-holders.
Higher equity requirements can distort the global level playing field for banks. And so what?
A common argument against stricter capital regulation is the famous “level playing field in regulation”: This simply means that, if Germany asks Deutsche Bank to raise proportionally more equity than the U.S. imposes on J.P. Morgan, this will create a competitive advantage for the latter and make it harder for Deutsche Bank to compete.
The authors mainly argue that, from the perspective of the general public, a competitive advantage for a bank has no merit as such. What counts is the risk that tax-payers incur (through implicit subsidies etc.) in return for the competitive advantage and whether such competitive advantage for a local bank is then still beneficial for the society. The answer to this question seems to be no.
In addition, for citizens in a country, the question is not whether local banks are successful in the context of global competition but whether local resources, namely people, find their most productive use.
Higher equity levels entail which other advantages?
Today’s “too big to fail” debate focuses pretty much on how to unwind banks in trouble. Two years ago, Anat Admati and Martin Hellwig wrote that this is wrong: We should focus more on how to avoid banks getting into trouble in the first place. And this is exactly what higher equity levels can do. They shift the risk from borrowers (or, through explicit or implicit guarantees, the general public) to the owners of a bank (i.e. shareholders) and, thus, make it less likely that a bank fails.
“If a bank has more equity and less debt, more of the downside of its activities will be borne by the bank and its shareholders rather than by creditors or taxpayers.”
If a bank runs short of liquidity, it might be obliged to sell its assets to generate cash. This type of urgent deleveraging can be very costly for a bank, simply because buyers will benefit from its desperate situation. More equity will soften this effect, as it gives banks more time to adjust its funding resources.
Finally, higher equity levels in banks could naturally reduce the size of the industry and the distortive effects of guarantees and subsidies that are predominant today.
What are the obstacles to higher equity levels in banks?
The book identifies five major impediments for higher bank equity:
First, interest paid to debt-holders is usually tax-deductible, dividend payments to shareholders are not.
“It is important to recognize that a corporate tax code that subsidizes debt and penalizes equity works directly against financial stability.”
Second, the banking industry relies excessively on ROE (return on equity) to measure performance. It then obviously makes sense for bank managers to lower equity as much as possible. For the society, however, this makes less sense, as it is the general public that ultimately bears the risk of low equity levels in banks.
Third, bankers often say that common considerations about equity levels and ROE cannot be applied to banking as this industry is “special”. Anat Admati and Martin Hellwig dispute this claim. They write that the only obvious difference between banks and other corporates is that, if the former are in trouble, they have a good chance to get government support. This is obviously no relevant argument in the discussion about higher equity levels in banks.
“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 the claims that are made is at risk of being declared incompetent to participate in the discussion.”
Fourth, banks using REPO transactions to fund their balance sheet favors borrowing instead of raising new equity. As a matter of fact, if lenders can benefit from the bank’s assets in the form of collateral, they feel more protected, keep on lending, and will deprive other creditors of these assets.
Fifth, the new Basel III regulation does not lead the way towards significantly higher equity levels: Required equity levels are still low and, in addition, rely broadly on complex risk-weighted asset calculations instead of the total asset levels. The new leverage ratio might help here.
Some additional quotes
At the beginning, the authors write that the purpose of their book is “to demystify banking and explain the issues to widen the circle of participants in the debate”. I would say that they have clearly achieved their goal.
The only thing I would criticize is that the authors primarily lead an academic debate without really taking into account the existing market situation. For example, the excessive focus on ROE in banking might be wrong. But, as long as investors ask for it, it doesn’t really matter whether ROE is a good or bad measure. It ultimately counts anyway. That’s a little bit like television: You cannot constantly complain about the low quality of the program, knowing that this is exactly what the public wants to watch…
Anat Admati, Martin Hellwig – The Banker's New Clothes