Banking and the Fear of Exchange Rate

Transcription

1 What s Wrong with Banking and What to Do About It Anat Admati Stanford University Money and Banking Conference Central Bank of Argentina November 15, 2013

2 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

3 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.

4 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

5 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

6 Are We Stuck? NO!! An Ounce of Prevention: More Equity! 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?

7 Bank Capital is Unborrowed Funding (Equity) Loans to productive enterprises Mortgages and other consumer loans Loss Absorbing Equity Trading Assets Other Debt reserves Deposits Assets Funding

8 Equity Absorbs Losses ( Bank capital NOT held or set aside, NOT cash reserve) Equity Solvent? A loss Equity Asset Value Debt Promises Asset Value Debt Promises Too Much Leverage More Equity

9 Equity Lowers Chance of Distress, Crisis Bailouts and Damage to Economy Bailout Equity Equity Debt DISTRESS Assets After DAMAGE TO THE ECONOMY Assets After Debt Too Much Leverage More Equity

10 Book Values can be Uninformative (Andrew Haldane, Capital Discipline, January 2011) 10

11 Market Values More Informative (Andrew Haldane, Capital Discipline, January 2011)

12 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. 12

13 Leverage (indebtedness) in Banking has Dramatically Increased in the Last 150 Years In 1840, equity funded over 50% of bank assets in US, elsewhere. 19 th 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.

14 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, 2 nd edition) % Debt Financing by Industry D/(E+D) (Market value E) 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 14

15 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.

16 The Benefits of More Equity for Banks Reduces likelihood of default and resulting costs. Protects economy from spillover effects of banks distress or failure. Shifts downside risk from taxpayers to shareholders who benefit from upside. Reduces intensity of deleveraging cycles and effect of distressed sales.

17 Benefits of More Equity for Banks, Cont. Reduces Too-Big-To-Fail subsidies, huge resulting inefficiencies. Reduces inefficiencies in investment decisions due to borrower-creditor/taxpayer conflicts: incentives for excessive risk taking. Underinvestment due to debt overhang, that can restrict credit (e.g., Sept. 2008). Reduces inefficiencies in funding decisions due to borrower-creditor/taxpayer conflicts: Resistance to leverage reduction Leverage ratchet (inefficient increases in leverage).

18 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.

19 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

20 Modigliani and Miller (M&M) and Banking A Five Decade Long Debate The main insight is NOT that the funding is ever irrelevant but: Redistributing risk among providers of funds does not by itself affect overall funding costs. The impact of any change in funding mix on overall funding costs is not due to the fact that some securities bear more risk than others and thus have higher required returns. The required return on any security depends on the risk it imposes on the investors, which depends on overall mix. This principle applies to any market-based funding, including equity and wholesale borrowing. Denying this principle is akin to denying gravity.

21 Bankers Prefer to Borrow, Resist Leverage Reduction DEBT 1. Leverage Ratchet 2. Tax subsidies 3. Safety net benefits 4. ROE fixation EQUITY

22 For Society, Excessive Bank Leverage is Expensive! DEBT 1. Leverage Ratchet 2. Tax subsidies 3. Safety net benefits 4. ROE fixation EQUITY 1. Reduces systemic risk 2. Reduces deadweight cost of distress, default, crisis 3. Reduces excessive risk taking 4. Improves ability to lend after losses

23 Debt (high levels of leverage create systemic risk and distort risk taking incentives) Funding Equity (provides cushion that absorbs risk and limits incentives for taking socially inefficient risk) Financial Markets And Greater Economy Loans

24 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 Funding Equity Financial Markets And Greater Economy. Higher Stock Price Loans Happy Banker, Gains are private Losses are social. Lower Loan Costs?

25 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. Same markets, same investors as other businesses. Inability to raise equity shows weakness, failed stress test. Recognize and unwind zombies (insolvent banks)!

26 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 are unreliable and unnecessary. Questionable loss absorption, especially in crisis. Non-equity securities maintain overhangs and inefficiencies. No justification from society s perspective.

27 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. Act as if banks only have liquidity problems. Liquidity problems do not occur in a vacuum. Solvency problems are much more dangerous. Supporting banks without reducing indebtedness does not help lending (Lender of Last Resort, LTRO, TARP)

28 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)

29 According to Mr. Ackermann 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. In Fact Well-designed capital regulation that requires much more equity, will increase the stability of banks. At the same time, it would enhance their ability to provide good loans to the rest of the economy and remove significant distortions. This may reduce the growth of subsidized banks. However, it will have a positive effects for all (except possibly bankers).

30 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.

31 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?

32 The BIG Picture A Mutual Funds A Mutual Funds B Investors B Investors C Banking Sector Assets Equity Deposits And Other Liquid Debt C Banking Sector Assets Equity Deposits And Other Liquid Debt All the Assets In the Economy Banking Sector All the Assets In the Economy Banking Sector All risks are held by final investors. Rearranging claims aligns incentives better. System is distorted, can t know the right size of banks or industry. Tradeoffs of more equity are not relevant from status quo.

33 A Huge Missed Opportunity Regulators have authority, lack Political will. Debate muddled by false, misleading narratives. Confusions. Willful blindness. Presumption that markets work, what we see is good. Banks are special myth. In fact, special in getting away with so much inefficient gambling. Capture, revolving door, resistance to change. No accountability. Unhealthy system is dangerous, a drag on economy.

34 Book intended to Educate, elevate debate. Provide specific policy guidance. Enlarge the circle of participants Create political pressure for action bankersnewclothes.com