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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 bankersnewclothes.com