Admati: Banks will be stronger with more equity

Admati

Expanding on an August 27 study that urged regulators to require banks to fund themselves with much more equity and less debt, four economists said today that in the real world banks have both equity and debt, and moving to more equity – and less repo borrowing, for example – would make banks stronger and better citizens.

More equity will help reduce the systemic risk that felled the credit markets in 2007 and 2008, suggests the March 16 version of “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive.”

The authors question the value of some debt. For example, they note that much of the demand for securitized banking – that is, securitization financed by repurchase loans and to a lesser extent by short-term IOUs called asset-backed commercial paper – came from banks that were trying to evade regulations. Bankers used securitized banking to game their equity requirements, avoid FDIC insurance and move into the shadow banking sector where they were less bothered by oversight. 

“This ‘regulatory arbitrage’ succeeded only because bank supervisors
allowed it,” the authors write.

Other observers doubt it will ever be possible for banks to have enough equity to cover the demands of repo and ABCPaper lenders when they’re in full flight.

They say the best way to deal with financial crises like the one in 2007-2008 is to set up a safety net for the repurchase market, something like the safety net already in place for commercial banks, which includes FDIC insurance paid for by the banks and access to the Federal Reserve’s discount window.

 They envision that the safety net would eliminate repo runs on banks in the same way that FDIC insurance eliminated depositor runs on banks 80 years ago.

But the four authors of this expanded study believe requiring banks to have more equity and less debt could avoid having to expand the safety net and the moral hazard – and costs to taxpayers – that go with it.

Some points from the revised study by Anat R. Admati, Peter M. DeMarzo, and Paul Pfleiderer at the Graduate School of Business, Stanford University, and Martin F. Hellwig at the University of Bonn:

— Higher equity requirements, by requiring that those who own residual claims in the bank bear much of the bank’s risk, reduce dependence on systems of guarantees and, instead, rely more on the private sector to provide safety to the financial system. Thus, they alleviate the distortions associated with the safety net.

Unfortunately, in recent years, the “safety net” of the banking sector seems to be expanding rather than contracting. According to Walter and Weinberg (2002), 45% of bank liabilities in the US were implicitly or, explicitly guaranteed in 1999. Malysheva and Walter (2010) estimate that this grew to 59% in 2008. Some have proposed recently that the safety net should be further expanded. For example, Gorton (2010, p.17), suggests expanding it to cover the so-called “shadow banking system” which, he argues “serves an important function, which should be recognized and protected.” In his words, “[c]reating a new Quiet Period requires that ‘bank’ debt be insured.” Gorton’s approach would result in further expansion of the safety net, which has the potential to further exacerbate the distortive incentives of guarantees.) …

— Given the huge costs of the system’s breakdown in the crisis, we see strong reasons to question the social value of much of this debt creation.

— The expansion of operations in the shadow banking system that contributed so disastrously to the crisis could easily have been avoided if regulators had used the powers that they had at their disposal. With practically no equity of their own, the shadow banking institutions involved in the recent crisis would have been unable to obtain any finance at all if it had not been for commitments made by sponsoring banks in the regulated system. These banks’ guarantees enabled the unregulated shadow banks to obtain funds by issuing asset-backed commercial paper.

— As Acharya and Richardson (2010) discuss, much of the activities in the shadow banking system can be explained by attempts to evade capital regulation and avoid deposit insurance fees.