Banks need more equity and less debt

Admati

The chorus of critics who say the new Basel III capital requirements are not going to be nearly strong enough to protect financial markets from another crisis just got a lot louder.

Twenty university professors headed by Anat Admati, professor of finance and economics at Stanford University, signed a letter that appeared in the Financial Times November 9, 2010, calling for much tougher rules.

Banks should get a lot more of their funding from equity, rather than debt, the group argues.

From their letter:

Banks’ high leverage and the resulting fragility and systemic risk contributed to the near collapse of the financial system. Basel III is far from sufficient to protect the system from recurring crises. If a much larger fraction, at least 15 per cent, of banks’ total,  non-risk-weighted, assets were funded by equity, the social benefits would be substantial. And the social costs would be minimal, if any.

One of the authors’ many points is that under Basel regulations, riskier assets require more equity. But regulators have a poor track record of gauging risk, and banks have shown themselves to be adept at gaming these rules.

The Basel accords determine required equity levels through a system of risk weights. This system encourages “innovations” to economise on equity, which undermine capital regulation and often add to systemic risk. The proliferation of synthetic AAA securities before the crisis is an example.

In the seven steps that RepoWatch has identified as leading to the crisis of 2007 and 2008, three were changes in how much capital, or equity, regulators said commercial and investment banks had to have to securitize.

For example, regulators decided AAA- and AA-rated mortgage-backed securities were less risky than home loans, and loans and securities held in off-the-books trusts were less risky than those held on the banks’ books.

So the global banks piled into securitization, created credit default swaps, collateralized debt obligations and off-the-books entities to reduce their capital requirements, and used the resulting securities as collateral for repo loans.

Each change in the rules, and each innovation to dodge them, made it more profitable for financial institutions to be securitized bankers.

It also dramatically increased their leverage, and when the crisis hit, the mega-banks did not have enough equity, or capital, to withstand the runs on their treasury, even though all of them appeared to meet capital standards.

The authors conclude:

Many bankers oppose increased equity requirements, possibly because of a vested interest in the current systems of subsidies and compensation. But the policy goal must be a healthier banking system, rather than high returns for banks’ shareholders and managers, with taxpayers picking up losses and economies suffering the fall-out.

Ensuring that banks are funded with significantly more equity should be a key element of effective bank regulatory reform. Much more equity funding would permit banks to perform all their useful functions and support growth without endangering the financial system by systemic fragility. It would give banks incentives to take better account of risks they take and reduce their incentives to game the system. And it would sharply reduce the likelihood of crises.