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“Fallacies, irrelevant facts, and myths” in banking

Four economists  from Stanford University and the University of Bonn have published a study essentially claiming that banks are full of it when they complain that it’s too expensive for them to raise money mainly by selling stock, like most companies do, and instead they need to use Other People’s Money (i.e. debt).

The study is part of the debate over whether the Basel III capital regulations go far enough to prevent another financial markets meltdown as happened in 2007 and 2008.

Regulators at the Bank for International Settlements in Basel, Switzerland, establish international capital standards (“capital” is bank jargon for equity) for financial institutions, and in October 2010 they issued revised rules in response to the crisis. The new rules are being called Basel III, because they’re the third try at getting this right. Basel I was in 1988 and Basel II in 2004.

From the October 20, 2010, study, by Anat R. Admati, Peter M. DeMarzo and Paul Pfleiderer from Stanford University and Martin F. Hellwig from the University of Bonn, “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is not Expensive”:

There is a pervasive sense in discussions of bank capital regulation that “equity is expensive” and that equity requirements, while beneficial, also entail a cost. The arguments we examine, which represent many of those most often made in this context, are fallacious, irrelevant, or very weak. Our analysis leads us to conclude that significantly higher equity requirements entail large social benefits and minimal, if any, social costs. We list below some of the arguments made against high equity requirements and explain why they are either incorrect or unsupported.

Some common arguments made against significantly increasing equity requirements:

Increased equity requirements would force banks to “set aside” or “hold in reserve” funds that can otherwise be used for lending. This argument confuses liquidity requirements and capital requirements. Capital requirements refer to how banks are funded and in particular the mix between debt and equity on the balance sheet of the banks. There is no sense in which capital is “set aside.” Liquidity requirements relate to the type of assets and asset mix banks must hold. Since they address different sides of the balance sheet, there is no immediate relation between liquidity requirements and capital requirements.

Increased equity requirements would increase banks’ funding costs because equity requires a higher return than debt. This argument is fallacious, because the required return on equity, which includes a risk premium, must decline when more equity is used. Any argument or analysis that holds fixed the required return on equity when evaluating changes in equity capital requirements is fundamentally flawed.

Increased equity requirements would lower the banks’ Return on Equity (ROE), and this means a loss in value. This argument is also fallacious. The expected ROE of a bank increases with leverage and would thus indeed decline if leverage is reduced. This change only compensates for the change in the risk borne by equity holders and does not mean that shareholder value is lost or gained. Shareholders willing to take additional risk can increase their average return by buying stock on margin.

Increased equity requirements would increase banks’ funding costs because banks would not be able to borrow at the favorable rates created by tax shields and other subsidies. It is true that, through taxes and implicit guarantees, debt financing is subsidized and equity financing is effectively penalized. Policies that encourage high leverage are distorting and paradoxical, because high leverage is a source of systemic risk. The subsidies come from public funds. If some activities performed by banks are worthy of public support, subsidies should be given directly to those activities.

Increased equity requirements would be costly since debt is necessary for providing “market discipline” to bank managers. While there are theoretical models that show that debt can sometimes play a disciplining role, arguments against increasing equity requirements that are based on this notion are very weak. First, high leverage actually creates many frictions. In particular, it creates incentives for banks to take excessive risk. Any purported benefits
produced by debt in disciplining managers must be measured against frictions created by debt. Second, the notion that debt plays a disciplining role is contradicted by the events of the last decade, which include both a dramatic increase in bank leverage (and risk) and the financial crisis itself. There is little or no evidence that banks’ debt holders provided any significant discipline during this period. Third, many models that are designed to attribute to
debt a positive disciplining role completely ignore the potential disciplining role that can be played by equity or through alternative governance mechanisms. Fourth, the supposed discipline provided by debt generally relies upon a fragile capital structure funded by short term debt that must be frequently renewed. Reduced fragility, which is a key goal of capital regulation, would be at odds with the functioning of this purported disciplining mechanism. Finally, one must ask if there are no less costly ways to solve governance problems.

Increased equity requirements would force or cause banks to cut back on lending and/or other socially valuable activities. First, higher equity capital requirements do not mechanically limit banks’ activities, including lending, deposits taking and the issuance of liquid money-like securities. Banks can maintain all their existing assets and liabilities and reduce leverage through equity issuance and the expansion of their balance sheets. That said, because equity issuance improves the position of existing creditors, and may also be interpreted as a negative signal on the bank’s health, banks might privately prefer to pass up lending opportunities if they must fund them with equity. However, this “debt overhang” problem can be alleviated if regulators require undercapitalized banks to recapitalize quickly by restricting equity payouts and mandating new equity issuance. Once better capitalized, banks would make better lending and investment decisions, because they would have reduced incentives to take excessive risk and indeed would be less affected by distortions due to debt overhang.

The fact that banks tend to fund themselves primarily with debt and have high levels of leverage implies that this is the optimal way to fund bank activities. It does not follow that just because financial institutions choose high leverage, this form of financing is privately or socially optimal. Instead, this observed behavior is the result of factors unrelated to social concerns, such as tax incentives and other subsidies, and to frictions associated with conflicts of interests and inability to commit in advance to certain investment and financing decisions.

See the study for more details and their recommendations.

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