Forcing banks to hold more capital may not always be wise
IN THE five years since Lehman Brothers failed, proposals to make the financial
system safer have proliferated. One of the few on which there is widespread
agreement is that banks should be less leveraged in other words, that they
should fund themselves more with equity and less with debt. This means a given
loss would be less likely to render a bank insolvent. But a new paper casts
leverage in a far more flattering light: it is necessary to meet the public s
demand for money-like assets.
This perspective is largely missing from the debate on just how much extra
equity banks should hold. Bankers argue that equity is dearer than debt.
Requiring them to issue more of it forces them to charge more on loans, hurting
economic growth. Rubbish, critics respond. As Franco Modigliani and Merton
Miller noted in 1958, other things being equal, the value of an enterprise does
not depend on its mix of debt and equity. If a bank issues more equity, it will
be less likely to go bankrupt. Its equity should be safer as a result, and
therefore cheaper. Forcing banks to reduce their leverage also has the
advantage of neutralising the subsidies that banks receive deposit insurance
and the implicit promise that any bank deemed too big to fail will be bailed
out.
Less bank leverage is not unambiguously good, however. Banks are useful not
just because they make loans but also because they issue debt in a form that is
extremely handy to the people that fund them. Like money, bank deposits are
highly liquid, a store of value, convenient for settling transactions, and
require no due diligence. The price of this convenience is that households get
less interest on their deposits than on bonds, a spread known as the liquidity
premium .
In a new paper Harry DeAngelo of the University of Southern California and Ren
Stulz of Ohio State University show that this premium means that banks, unlike
other firms, are not indifferent to leverage, as the Modigliani-Merton theorem
suggests. Mr DeAngelo and Mr Stulz show that it is better for banks to be
highly levered even without frictions like deposit insurance and implicit
guarantees. Banks would still choose to be levered because the liquidity
premium lets them borrow cheaply.
Their model can explain a historical curiosity. Banks capital ratios have
fallen steadily over the past two centuries. This has often been attributed to
the introduction of deposit insurance and the role of lenders of last resort,
which reduced the cost of bank debt. But in America s case much of the drop in
borrowing costs came before the creation of the Federal Reserve in 1913 and the
introduction of federal deposit insurance in 1933. An alternative explanation
is that as banking became more competitive, lenders were forced to offer better
terms to depositors, narrowing the liquidity premium. The model of Messrs
DeAngelo and Stulz shows that as the liquidity premium shrinks, banks must
crank up their leverage to compensate.
If leverage meets the demand of borrowers for a safe, money-like investment,
forcing banks to reduce their leverage may have nasty side-effects. Imagine a
bank that, instead of issuing $9 in deposits and $1 in equity, issues $8 in
deposits and $2 in equity. One option is for the public to hold $1 less in
deposits and $1 more in equity, thereby assuming more risk than it would
prefer. More likely, shadow banks (institutions that act like banks but are
not regulated like them) would step in to meet the public s unmet demand for
money-like assets. As shadow banks take over some of the banks responsibility
for producing money-like assets, the financial system becomes more fragile.
Another paper by Gary Gorton, Stefan Lewellen and Andrew Metrick, all of Yale
University, finds that although the volume of financial assets in America has
grown dramatically since 1952, the proportion they consider safe has remained
at around 33%. But the mix of these safe assets has shifted from government
debt and bank deposits towards quasi-safe shadow-banking debt: commercial
paper, repo loans and money-market funds.
Even before the crisis, restrictions on leverage played a part in this shift.
Banks sought to conserve their capital by moving mortgage-backed securities to
off-balance-sheet vehicles, financed with short-term paper. Investment banks
financed their mortgage holdings with repo loans. Investors treated these IOUs
as money, giving little thought to the collateral they received. When the
mortgage market collapsed, what investors thought were riskless, liquid assets
turned out to be risky and illiquid.
Five years since Reserve Primary, too
The push for lower leverage since the crisis has yet to spawn similar
side-effects because banks have been chasing deposits to replace wholesale
funding. But in time, more equity could constrain banks capacity to supply
people with money-like assets, pushing them into the arms of shadow banks.
Hence regulators continued worries about money-market funds. Such funds try to
maintain a constant $1 per share net asset value, which encourages investors to
treat them as cash. Technically, though, they are equity investments: funds can
pay out less than a dollar. That s what the Reserve Primary Fund did when its
holdings of Lehman paper went bad, sparking a broader run on money-market
funds.
The European Commission has proposed compelling money funds to have a
predefined capital buffer. America s Securities and Exchange Commission is
calling on funds either to float their share prices or limit withdrawals during
times of stress. Both want investors to stop treating investments in
money-market funds as money. A laudable goal, but one with its own downside:
investors may head off in search of another money-like asset in another
penumbral corner of the system.
Sources
Why High Leverage is Optimal for Banks , by Harry DeAngelo, University of
Southern California, and Rene M. Stulz, Ohio State University, NBER & European
Corporate Governance Institute Working Paper, August 2013
The Safe-Asset Share , Gary Gorton, Stefan Lewellen and Andrew Metrick, Yale
School of Management, National Bureau of Economic Research Working Paper,
January 2012
The Cost of Capital, Corporation Finance and the Theory of Investment", by
Franco Modigliani and Merton Miller, The American Economic Review, June 1958
Do the M & M propositions apply to banks? , by Merton Miller, Journal of
Banking & Finance, 1995
Misunderstanding Financial Crises , by Gary Gorton, Oxford University Press,
2012
The Bankers New Clothes , by Anat Admati and Martin Hellwig, Princeton
University Press, 2013