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What’s Wrong with Banking
and What to Do about It
Presented by
Anat Admati
Stanford University
September 20, 2013
Our Banking System?
• is too fragile and dangerous
• exposes the public to unnecessary risks
• distorts the economy
• suffers from severe governance problems
• is not regulated effectively in most countries
• does not support the economy as well as it can
What Makes the System Fragile?
• High indebtedness (leverage)
– Distress and insolvency
• Reliance on deposits and short-term debt
– Liquidity problems and runs.
• Interconnectedness
– Contagion effects
• Flawed and ineffective regulation
– Off balance sheet commitments
– Shadow banking
– Over-the-counter derivatives
– Risk weights.
Distortions and Inefficiencies
• Too- big/systemic/opaque-to fail/control/regulate.
– large subsidies distort competition
– perverse incentives and ability to grow inefficiently.
• Inefficient lending and investment.
– bias against business loans, in favor of trading, gov’t loans.
– too much or too little lending
• Severe governance and control problems
–
–
–
–
bankers take risks, benefit from upside
shareholders may not be sufficiently compensated for risk
creditors and taxpayers share downside
society suffers from instability and inefficiency
What to do?
• Better resolution. Essential, but,
– cross border issues
– trigger unclear, political
– disruptive and costly even in the best case
– distress is already destabilizing and harmful
• Ring fencing, Glass-Steagall, Volcker. Possibly, but
– concern for depositors not only reason for systemic
concerns (LTCM, Bear Stearns, Lehman, AIG)
– no-bailout commitments are not credible.
– interconnectedness remains.
– “too many to fail”
Are We Stuck? NO!!
• Analogy 1:
–
–
–
–
Banks: addicted to “polluting” behavior (borrowing).
Recovery/resolution: cleanup of polluted river.
Bailouts/guarantees: encourage & subsidize pollution.
Instead: Is there a cleaner alternative?
• Analogy 2:
–
–
–
–
Banks: speeding trucks with explosive cargo.
Recovery/resolution: emergency plan for explosions.
Bailouts: encourage & subsidize reckless driving.
Instead: Can we put & enforce safer speed limits?
An Ounce of Prevention:
Reduce Excessive Indebtedness!!
• Reduce likelihood and cost of distress, failure,
contagion, liquidity problems, runs, distressed sale,
credit crunches.
• Reduce distortive subsidies delivered via easy
borrowing.
• Shift downside risk from taxpayers to investors.
• Enable banks to lend in downturns, reduce
inefficiencies in lending/investment.
• Correct leverage ratchet, given credit market failure.
• Best bargain: Large benefits, virtually no social cost!
Bank Capital is Loss-Absorbing Funding
Loss
Absorbing
Equity
Loans to
productive
enterprises
Mortgages
and other
consumer
loans
Other
Debt
Trading
Assets
reserves
Deposits
Assets
Funding
Debt, Including Deposits, is a Legal Promise
Promised
Payment
Beware of Confusing Language!!
• Equity (“capital”) is not cash reserves.
• Capital requirements concern funding.
–Do not constrain loans or investments.
• Confusion implies false tradeoffs.
• “Hold more capital” = use more equity
and less borrowed money to fund.
Equity Absorbs Losses
(“Bank capital” NOT “held” or “set aside,” NOT cash reserve)
Solvent?
A loss
Equity
Equity
Asset
Value
Debt
Promises
Too Much
Leverage
Asset
Value
Debt
Promises
More Equity
Equity Lowers Chance of Distress, Crisis
Bailouts and Damage to Economy
Bailout
Equity
Equity
Debt
Assets
After
Too Much
Leverage
DISTRESS
DAMAGE TO
THE ECONOMY
Assets
After
Debt
More Equity
IFRS Total $4.06 Trillion
JPMorgan Chase
Balance Sheet
12/31/2011
Loans = $700B <
Deposits = $1.1T
Other debt (GAAP): $1T
Other debt (IFRS): $1.8T
Cash
Loans
GAAP Total $2.26Trillion
Cash
Loans
Deposits
Trading and
Other
Assets
Other
Debt
(mostly
short-term)
(GAAP allows more netting.)
Equity (book): $184B
Equity (market): $126B
Significant commitments off
balance sheet
Deposits
Long-Term
Debt
Equity
Trading and
Other
Assets
Other
Debt
(mostly
short-term)
Long-Term
Debt
Equity
History of Banking Leverage in US and UK
(Alesandri and Haldane, 2009)
Why?
Source: US: Berger, A, Herring, R and Szegö, G (1995). UK: Sheppard, D.K (1971), BBA, published
accounts and Bank of England calculations.
14
Leverage (indebtedness) in Banking has
Dramatically Increased in the Last 150 Years
• In 1840, equity funded over 50% of bank assets in US,
elsewhere.
• 19th century: banks were partnerships with unlimited
or increased owner liability.
• Bank equity did not have limited liability everywhere in
the US until 1940s.
• Equity ratios declined consistently to single digits.
• Evidence that growing “safety nets” played a role.
• Observed equity levels are far from efficient.
% Debt Financing by Industry D/(E+D) (Market value E)
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
Cons. Fin. Svcs.
Investment Services
Auto & Truck Manufacturers
Real Estate Operations
Electric Utilities
Airline
Insurance (Life)
Insurance (Prop. & Casualty)
Natural Gas Utilities
Hotels & Motels
Forestry & Wood Products
Conglomerates
Paper & Paper Products
Railroads
Casinos & Gaming
Auto & Truck Parts
Average (All U.S. Firms)
Construction Services
Retail (Grocery)
Communications Services
Motion Pictures
Food Processing
Healthcare Facilities
Broadcasting & Cable TV
Advertising
Beverages (Alcoholic)
Retail (Department & Discount)
Tobacco
Beverages (Nonalcoholic)
Printing & Publishing
Restaurants
Computer Services
Oil & Gas - Integrated
Retail (Specialty)
Major Drugs
Computer Hardware
Medical Equipment & Supplies
Biotechnology & Drugs
Computer Networks
Retail (Apparel)
Semiconductors
Communications Equipment
Computer Peripherals
Computer Storage Devices
Software & Programming
Leverage by Industry
(Corporate Finance, Berk and DeMarzo, 2nd edition)
0%
16
Facts
• Non-banks make risky, long term, illiquid
investments.
• US average: 70% equity/assets (market value).
• Non-banks rarely maintain less than 30% equity
(without regulation).
• Profits are popular source of unborrowed funds.
• Berkshire Hathaway never pays dividends.
• Banks with less than 10% equity make payouts,
expect to be trusted to invest borrowed money.
Two Highly Related Questions
• Why do we see banks so highly leveraged?
– What are the incentives?
• Is high leverage necessary? Is it “good”?
– Is fragility inevitable?
– Is fragility valuable?
– Are Basle III capital requirements at the right
level?
Why Not Much More Bank Equity?
Mantra:
“Equity is Expensive!”
Why exactly?
For whom?
Fallacy: “Equity is expensive because it has a
higher required return than debt”
• Contradicts first principles of finance: the cost of capital
is determined by risk to which it is exposed.
• Fixing the assets, lower leverage (less debt and more
equity financing) lowers the required return on equity,
because equity becomes less risky.
• Someone must absorb losses on investments.
• Redistributing risk among providers of funds does not by
itself affect overall funding costs.
Modigliani and Miller (M&M) and Banking
A Five Decade Long Debate
• The main message of Modigliani and Miller (1958) is NOT
that the capital structures of banks, or of any firm, are
irrelevant.
• The impact of any change in funding mix must be examined
through its effect on how it changes the total cash available
from investments.
– This principle applies to banks and non-banks.
– This principle applies to any market-based funding
(deposit that provide service are a bit different).
– Denying this principle is akin to denying gravity.
Funding Considerations for Non-Banks
• Debt has a tax advantage.
• Debt has a “dark side”
– Deadweight costs of default and bankruptcy.
– Agency costs: Conflicts of interest lead to distorted, suboptimal investment and funding decisions: underinvestment,
excessive risk taking, leverage ratchet (“addiction” to
borrowing).
• Dark side increases borrowing costs.
– Higher interest rates, debt covenants that reduce flexibility.
Funding Considerations for Banks
• Debt (sometimes even hybrid) has tax advantage.
• Underpriced guarantees are a subsidy of debt.
– Bankruptcy costs not borne by bank investors.
– Creditors do not care about risk, thus borrowing costs do not
reflect the riskiness of the assets. No debt covenants.
• Deadweight bankruptcy costs are borne by
governments.
• Once debt is in place, owners/shareholders resist more
equity. Guarantees feed addiction to borrowing,
creating more distortions and inefficiencies.
Equity, Risk, and Return on Equity (ROE)
• More equity
25%
– Reduces ROE in good times
20%
– Raises ROE in bad times
15%
– Reduces risk of equity
10%
– Reduces required return on
equity
• Unless leverage and risk are
fixed, ROE comparisons are
meaningless.
ROE
(Earnings
Yield)
Initial
10% Capital
Recapitalization
to 20% Capital
5%
0%
3%
4%
5%
-5%
-10%
-15%
Return on Assets
(before interest expenses)
6%
7%
ROE is Irrelevant,
ROE focus is Dangerous
• Raw return on Equity (ROE), unadjusted for risk, does not measure
shareholder value.
• Chasing returns creates incentives to gamble, borrow excessively.
• Consider two managers:
– Good manager manages assets well and has a prudent level of equity funding
– Bad manager manages assets poorly and has an imprudent level of equity funding
Realized Return
on Assets (ROA)
(Before Interest Payments)
Interest Rate
on Debt
% Equity
Funding
Realized Return
on Equity (ROE)
Good Manager
3.00%
2.00%
10.00%
12.00%
Bad Manager
2.50%
2.00%
3.00%
18.67%
Leverage Ratchet
• Leverage can be addictive to heavy borrowers.
• Once debt is in place, reducing leverage is a gift to
creditors (or the government), makes debt safer.
• Because banks’ creditors, e.g., depositors, do not do
much to counter, leverage is easy to increase but
bankers/shareholders resist reducing it.
• Maturity rat race: repeated borrowing at shorter
maturity, effective seniority over previous creditors.
Bankers Prefer to Borrow, Resist Leverage Reduction.
1
1.
2.
3.
4.
3
2
DEBT
Leverage Ratchet
Tax subsidies
Safety net benefits
ROE fixation
EQUITY
For Society, Excessive Bank Leverage is “Expensive!”
2
1.
2.
3.
4.
DEBT
Leverage Ratchet
Tax subsidies
Safety net benefits
ROE fixation
1.
2.
3.
4.
1
3
EQUITY
Reduces systemic risk
Reduces deadweight cost of distress,
default, crisis
Reduces excessive risk taking
Improves ability to lend after losses
Debt
(high levels of
leverage
create systemic
risk
and distort risk
taking incentives)
Funding
Financial
Markets
And
Greater
Economy
Loans
Equity
(provides
cushion that absorbs
risk and
limits incentives
for taking
socially inefficient risk)
Government Subsidies to Debt:
1. Tax shield (interest paid is a deductible expense but not dividends)
2. Subsidized safety net lowers borrowing costs; bailouts in crisis.
Debt
Debt
Funding
Financial
Markets
And
Greater
Economy
.
Equity
Equity
Higher Stock Price
Happy Banker,
Gains are private
Losses are social.
Loans
Lower Loan Costs ?
Implicit Guarantees
Impose Large Costs on Society
• encourage excessive, dangerous leverage
– feed leverage ratchets (“addiction” to borrowing).
– enable maturity rat race, more fragility.
• lead to inefficient investments
– debt overhang causes underinvestment in valuable loans.
– excessive risk taking (boom), then credit crunch (bust)
• create other perverse incentives
– reward excessive growth, interconnectedness, complexity.
– no accountability can encourage recklessness, fraud, front
running, manipulation.
• outsized subsidies distort competition and economy.
Distortive Subsidies
• Substantial evidence using different methodologies.
• Value higher in distress, increases with risk, leverage, size.
• No scale economies above $100B adjusting for subsidies.
Davies, Richard, and Belinda Tracey, “Too Big to Be Efficient? The Impact of Implicit Funding
Subsidies on Scale Economies in Banking,” 2012.
The Big Challenge: Wedge between Private
Incentives and the Public Good
• It is straightforward to neutralize the tax subsidy.
– Abolish corporate tax
– No deductibility above certain leverage level
– Tax incentives to equity
• Difficult and undesirable to commit to no bailouts
– Charging for guarantees is difficult, moral hazard remains.
– Prevention is even more critical.
• Equity is the best preventative approach:
– Self insurance at market price!
Balance Sheets and Pro-Cyclicality
• Three possible ways to reduce leverage
– Note: Asset sales (“deleveraging”) is the fastest.
– Exacerbates liquidity problems, credit crunch in downturns/crisis.
– Key: Much more equity, conservation buffer, controlling the dynamics.
Initial Balance Sheet
(10% Capital)
Balance Sheets with Reduced Leverage (higher equity to assets)
(20% Capital)
New Assets: 12.5
Equity: 10
Loans & other
Assets: 100
Deposits & Other
Liabilities: 90
Equity: 22.5
Equity: 20
Equity: 10
Loans & other
Assets: 100
Deposits & Other
Liabilities: 80
Loans & other
Assets: 100
Deposits & Other
Liabilities: 90
Loans & other
Deposits & Other
Assets: 100
Liabilities: 40
A: Asset Sales
B: Recapitalization
C: Asset Expansion
34
Deleveraging “Spirals”
A 1% Asset Decline with 3% equity …
 33% Balance Sheet Contraction
•
•
•
Equity
Distressed asset sales
Illiquidity / market failure
Bailouts
1%
Asset
Liquidation
Loans &
Investm
ents
Assets
Debt
Liabilities
33%
Loans
&
Invest
ments
Assets
Equity
Debt
Liabilities
35
Reducing the Fragility of Individual Banks
is Key to Addressing Systemic Risk
• If all (or most) individual institutions are safer, the
system is less likely to experience runs, contagion,
multiple failures.
• Note: Shadow banking institutions cannot be ignored,
all risk must be considered.
• Easiest remedy: more equity funding, less leverage!
• Proposed alternatives are more complex, less clearly
beneficial.
Greenspan on More Equity
• “Had the share of financial assets funded by equity been
significantly higher in September 2008, it seems unlikely that the
deflation of asset prices would have fostered a default contagion
much, if any, beyond that of the dotcom boom.”
“The Crisis,” Brookings paper, April 15, 2010.
• “.. if capital and collateral are adequate...losses will be restricted to
equity shareholders who seek abnormal returns; Taxpayers will not
be at risk. Financial institutions will no longer be capable of
privatizing profit and socializing losses.”
Quoted in “Greenspan Defends Legacy, Urges
Higher Capital, Collateral Standards,” WSJ, April 7, 2010.
Balance Sheet Realities
• Contingent and other liabilities (and assets) live
off balance sheet.
– Special Purpose Vehicles, Money Market Funds, etc.
– Can show up suddenly on balance sheet.
• Loan accounting is highly problematic.
• IFRS vs GAAP: derivatives netting must be
meaningful when it matters, i.e., in default.
• Accounting tricks (Repo 105).
How Much Is “Enough” Bank Capital?
• Much more than Basel III levels.
– Benchmark: eliminate TBTF, make banks “normal” in
approach to investment.
– Significant social benefits; what is the relevant cost?
• Viable banks can raise equity at appropriate prices.
– “Dilution” from less subsidies and equity bearing
more downside.
– Inability to raise equity flags insolvency.
• Risk weights are very problematic, distort lending
decisions, hide risk, are manipulable.
How Much Equity?
• Basel II and Basel III Capital Requirements
– Tier 1 capital Ratio: Relative to risk-weighted assets:
• Basel II: 2%,
• Basel III: 4.5% - 7%.
• Definitions changed on what can be included.
– Leverage Ratio: Relative to total assets:
• Basel II: NA
• Basel III: 3%.
• US: 5% for large BHC, 6% for insured subs.
• Requirements based on flawed analyses of tradeoffs.
• Huge social benefits to higher requirements; no relevant cost.
– Banks should be made to care more about downside risk.
Is Basel III “Tough?”
“Tripling the previous requirements sounds tough, but
only if one fails to realize that tripling almost nothing
does not give one very much.”
“Basel III, the Mouse that Did Not Roar,” Martin Wolf, Financial Times,
September 13, 2010
“How much capital should banks issue? Enough so that
it doesn't matter! Enough so that we never, ever hear
again the cry that "banks need to be recapitalized" (at
taxpayer expense)!”
“Running on Empty,” John Cochran, Wall Street Journal
March 1, 2013
Making Equity Regulation Work
• Maintain equity between 20-30% of total assets.
– Include all relevant exposures.
– Use market signals for prompt corrective action.
• Ban payouts to build up equity.
• Mandate equity issuance: viable banks can raise
equity at appropriate prices.
– No scarcity, same markets, same investors as other
businesses.
– Inability to raise equity shows weakness, failed “stress test.”
– Unwind zombies!
More Flaws in Basel Approach
• Risk weighting system highly problematic.
– Ratios are “too complex to verify, too error-prone to be
robust, too leaden-footed to enable prompt corrective
action.” (Haldane)
– Illusion of “science;” but ignores key risks (interest rate).
– Distortive, e.g., favors government over business lending.
• Alternatives to equity unreliable and unnecessary.
– Questionable loss absorption, especially in crisis.
– Non-equity securities maintain overhangs and
inefficiencies.
– No justification from society’s perspective.
Misguided Approaches
• Delay recognizing losses, excessive forbearance.
– Weak/zombie banks are dysfunctional for economy.
– Hidden insolvencies are dangerous, delays are costly.
– “Time has trick of getting rotten before it gets ripe.”
• View every problem as “just a liquidity problem.”
– Liquidity problems do not occur in a vacuum.
– Solvency problems are much more dangerous.
– Supporting banks without reducing indebtedness does
not help lending (LTRO, TARP)
Trends: Total Assets Grew, RWA Not Much
More Trading, Fewer Loans and Deposits
International Monetary Fund Global Financial Stability Report, April 2008
45
Book Values can be Uninformative
(Andrew Haldane, “Capital Discipline,” January 2011)
46
Market Values More Informative
(Andrew Haldane, “Capital Discipline,” January 2011)
The Purported Tradeoff
(Recall: Credit and Growth Suffered greatly)
“More equity might increase the
stability of banks. At the same time,
however, it would restrict their ability
to provide loans to the rest of the
economy. This reduces growth and has
negative effects for all.”
Josef Ackermann, CEO of Deutsche Bank
(November 20, 2009, interview)
According to Mr. Ackermann
In Fact
Well-designed capital
More equity might increase the regulation that requires much
stability of banks.
more equity, will increase the
stability of banks.
At the same time, it would
At the same time, however, it
enhance their ability to provide
would restrict their ability to
good loans to the rest of the
provide loans to the rest of the
economy and remove
economy.
significant distortions.
This may reduce the growth of
This reduces growth and has
subsidized banks. However, it
negative effects for all.
will have a positive effects for
all (except possibly bankers).
Invalid “Level Playing Field” Argument
• Banks can endanger an entire economy (Ireland,
Iceland, Cyprus).
• Banks compete with other industries for inputs
(including talent); subsidies distort markets.
• Not a national priority that “our” banks are
successful if they impose risk and cost on us.
• Argument creates “race to the bottom.”
“Shadow Banking” Bugbear
• Crisis exposed ineffective enforcement.
– Regulated banks sponsor entities in the
shadow banking system.
• Enforcement challenge invalid argument
against regulation:
– Allow robbery?
– Give up tax collection?
The BIG Picture
Mutual
Funds
A
Equity
C
Banking
Sector
Assets
All the Assets
In the Economy
B
Investors
B
Deposits
And
Other
“Liquid”
Debt
Banking Sector
Mutual
Funds
A
Investors
Equity
C
All the Assets
In the Economy
Banking
Sector
Assets
Deposits
And
Other
“Liquid”
Debt
Banking Sector
• All risks are held by final investors. Rearranging claims aligns incentives better.
• Key question: Are all productive activities taken? Is risk spread efficiently?
• A lot of funding in the economy not through banks.
Sad State of Financial Reform
• Much talk, little effective action, repeated mistakes.
• Regulators have authority, lack mostly the will to act.
• Debate muddled by nonsense and politics.
– False, misleading claims and narratives.
– Wrong presumption that markets work.
– Capture, revolving door, resistance to change.
– No accountability (abstract risk, diffuse responsibility).
– “Banks are special” myth. (In fact, Banks are special mainly
in getting away with so much inefficient gambling.)
• Unhealthy system is dangerous, drag on economy.
Book intended to
• Educate, elevate
debate.
• Provide specific
policy guidance.
• Enlarge the circle of
participants
• Create political
pressure for action
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