Debt Overhang and Capital Regulation

Transcription

1 Debt Overhang and Capital Regulation Anat Admati INET in Berlin: Rethinking Economics and Politics The Challenge of Deleveraging and Overhangs of Debt II: The Politics and Economics of Restructuring April 13, 2012

2 Debt Overhang and the Burden of Debt Debt, once taken, is a burden on borrower. Debt = hard, legal commitments that would not go away Debt must be paid or restructured, or the borrower defaults; Additional investment requires new funds, which are raised at prices reflecting the current creditworthiness of the borrower. If the borrower is distressed, raising new funds becomes expensive to the borrower. The debt overhang effect can interfere with the borrower s ability, or willingness, to invest and grow: Crises: Households, governments and banks borrowed too much in the last decade and many are distressed. Debt overhang is a big problem. Debt overhang is among the many inefficiencies associated with high leverage/indebtedness.

3 Two Types of Questions What to do now? How does leverage get reduced? How do good investments resume? Who controls this process? Interaction of borrowers, creditors, regulators and (even other) governments. How to prevent such situations in the future? Can credit bubbles be stopped? How do governments make sound fiscal decisions? What is the role of bank capital regulation? What is the politics of financial reform and regulation?

4 Focus on Banks and Capital Regulation Banks and financial institutions at the very center of crisis and current crisis in Europe. Ever larger, universal, TBTF banks in UK, US, Europe. Highly leveraged, particularly on total balance sheet. Some are insolvent, which goes unrecognized (very bad). Excessive borrowing of households and governments highly related to excessive lending by banks, and banks own excessive leverage. Securitization reduced skin in the game, lower credit standards, increased risk. Innovation to evade regulation, motivated by distortive risk weights system. Zero risk weight for AAA securities and government debt increases systemic risk, biases against business lending.

5 Historical Facts About Bank Capital In 1840, equity funded over 50% of bank assets in US. Over the subsequent century equity ratios declined consistently to single digits. Steps to enhance safety net contributed to this. In the US: National Banking Act, 1863, Creation of the Fed, 1914, Creation of FDIC, Similar trends in UK, Germany. Bank equity did not have limited liability everywhere in the US until 1940s!

6 History of Banking Leverage in US and UK (Allesandri and Haldane, 2009) Source: US: Berger, A, Herring, R and Szegö, G (1995). UK: Sheppard, D.K (1971), BBA, published accounts and Bank of England calculations. 6

7 The Denominator in the Capital Ratio is Risk Weighted Assets International Monetary Fund Global Financial Stability Report, April

8 Deleveraging Spirals A 1% Asset Decline with 3% equity 1% Equity Asset Liquidation 33% Balance Sheet Contraction Asset Fire Sales Illiquidity / Market Failure Reg. Uncertainty / Bailouts 33% Equity Loans & Investm ents Debt Loans & Invest ments Debt Assets Liabilities Assets Liabilities 8

9 A Direct Attack on Fragility: Much More Equity, Much Less Leverage! Distress, insolvency, default is extremely costly and disruptive, can lead to bailouts. Imposing losses on debt holders is legally complex, especially for global banks. Runs don t happen out of blue. Pure liquidity problems are easy to solve if solvency is not a concern. Reduces moral hazard: better incentives to manage risk, more skin in the game for shareholders, managers.

10 Mantra: Equity is Expensive Why exactly and in what sense? Are banks prevented from providing useful services by high equity requirements? Do their costs increase? If so, why and for whom? Given benefits of more equity, critical to assess before accepting that high leverage and fragility are essential. Bottom line: Bank equity is expensive for banks, but a bargain for society. Capital regulation critically important but highly political. Policy makers seem to lack the will to do it right.

11 Basic Smell test Equity has higher required return than debt for every corporation; more leverage would increase (average) ROE for every corporation. Yet non-financials never choose anywhere near 90%-95% debt. (No regulation preventing it!) average public corporation has 70% equity. Consider Apple: 100% equity funded, $570B market value. If equity is expensive, why wouldn t Apple do a leveraged recapitalization? It can borrow, say, $20 billion and reduce equity, even save on taxes.

12 Standard Funding Considerations Debt has tax advantages. More debt increases deadweight costs of default and bankruptcy. Leverage creates conflicts of interest and inefficient decisions that benefit shareholders (and managers). excessive risk-taking, debt overhang underinvestment, resistance to reduce leverage These agency costs can increase borrowing costs and reduce value of the leveraged firm. Private market approach: debt covenants. Banks (should) worry about such problems when lending.

13 Funding Considerations for Banks Tax code favors debt. Deposits and other debts are part of a subsidized safety net. This means borrowing costs do not reflect the riskiness of the assets. Safety net takes many forms. Bankruptcy or resolution costs are not borne by investors at the time of failure. Investors do not jointly bear all the risk of the investments; taxpayers (or FDIC) bear downside. Little tradeoffs for managers! Economize on equity. ROE focus encourages leverage and risk, exacerbates inefficiencies of high leverage.

14 Regulation Debate must Focus on Social Costs & Benefits Paradox: debt is subsidized, equity penalized despite negative externalities of high leverage. fragility and systemic risk, Inefficiencies (excessive risk, debt overhang) Lost subsidies are not a social cost! Are subsidies justified or necessary? Dilution of current equity if leverage is reduced benefits creditors/taxpayers; not a social cost!

15 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

16 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?

17 Private Comparison of Equity and (non deposit) Debt DEBT 1. Subsidies (taxes and safety net) 2. ROE fixation 3. Debt overhang EQUITY

18 SOCIAL Benefits of Equity and (non demand deposit) Debt DEBT 1. Subsidies (taxes and safety net) 2. ROE fixation 3. Debt overhang EQUITY 1. Reduces systemic risk 2. Reduces deadweight cost of distress, default, crisis 3. Reduces inefficiencies of high leverage (excessive risk, debt overhang)

19 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!

20 How Much Equity? Basel II and Basel III Capital Requirements Tier 1 capital Ratio: Equity to risk-weighted assets: Basel II: 2%, Basel III: 4.5% - 7%, up to 9.5% for SIFIs. Definitions changed; Tier II very flawed, not useful. Risk weights still allowed not to reflect true risk, use banks own risk model, complicated. Leverage Ratio: Equity to total assets: Basel II: NA Basel III: 3%. Basel numbers based on flawed analyses of tradeoffs. Asymmetric Loss Function Consequences of too little: financial crisis, instability, distortions. What would be too much and what would be consequences??

21 Implementation Issues Why not 20-30% of total?? Easiest source of equity: retained earnings: Banks have access to equity markets. valuation depends on risk and return dilution due to debt overhang effect and lost subsidies, for a good cause, benefits diversified shareholders. Inability to raise equity at any price flags possible insolvency. Requirements should not be one number Need a range to have free capital. Must find better way to calibrate risk. Basel does not even calibrate for interest rate risk!

22 Balance Sheets and Transitions Three possible ways to reduce leverage Note: Recapitalization and expansion maintain assets. Expansion maintains assets and liabilities. Initial Balance Sheet (10% Capital) Equity: 10 Balance Sheets with Reduced Leverage (higher equity to assets) (20% Capital) New Assets: 12.5 Equity: 20 Equity: 22.5 Loans & other Assets: 100 Deposits & Other Liabilities: 90 Equity: 10 Loans & other Assets: 100 Deposits & Other Liabilities: 40 Loans & other Assets: 100 Deposits & Other Liabilities: 80 Loans & other Assets: 100 Deposits & Other Liabilities: 90 A: Asset Sales B: Recapitalization C: Asset Expansion 22

23 Transition Issues Shareholders, and particularly bank managers, will resist leverage reduction. Loss of subsidies Debt overhang effect: value is transferred from shareholders to creditors and the government. Leverage is addictive through a ratchet effect (may increase, but not decrease) Resistance due to debt overhang exists no matter how leverage reduction is achieved. If assets are homogeneous with one class of debt, all methods of leverage reduction result in the same private loss for shareholders. If shareholders can repurchase junior debt, deleveraging through asset sales are preferred. Bank preference depends on asset market interactions and frictions. Risk weights, accounting, play a role but should not.

24 Transition Issues and Lending Credit crunch due to excessive leverage, not too much equity. Debt overhang is the critical effect. A bank with 25% equity makes better lending decisions than one with 5% equity: Issue is only in transition Some asset sales are fine, even good. Risk weight system discourages lending. To prevent inefficient lending reduction, regulators can control leverage reduction. It is most critical to reduce cash payouts that deplete equity. Can mandate equity issuance. Ban dividends and share buybacks during transition. FPC in B of E (brilliant): pay bonus with new equity!

25 Other Arguments in the Politics of Debate Level Playing Field Concerns are invalid. Banks can endanger an entire economy (Ireland, Iceland); national taxpayers bear the costs. Banks compete with other industries for inputs (talent). Misguided subsidies distort the market process. Argument create race to the bottom. Concern with shadow banking points to an enforcement issue that must be tackled anyway. The crisis exposed ineffective enforcement. Regulated banks sponsored entities in shadow banking. Should we give up tax collection because of loopholes? Again, issue is the political will and desire to be effective.

26 Summary: Effective Reform is Essential The financial system is excessively fragile. Fragility is an neither necessary nor useful. Regulation is critical; conflicted interests and externalities are not resolved by markets. Much higher equity requirements attack fragility and correct distortions and inefficiencies. Resistance from bankers is based on private considerations, conflicted with public on this. Basel III is flawed and insufficient.

27 Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive August, 2010, revised March 2011 Debt Overhang and Capital Regulation March 2012 Anat R. Admati Peter M. DeMarzo Martin F. Hellwig Paul Pfleiderer