Study on crisis leverage barely mentions repos

Acharya

Most of the leverage in the shadow banking system comes from repurchase transactions, but a new study of the build-up of bank leverage 2000-2009 barely mentions it because of the difficulty of getting repo data.

The study shows that commercial and investment banks grew rapidly 2000-2007 mainly by taking on debt, not by increasing equity. The authors attribute the increase in bank leverage in part to growing reliance on the sale of unsecured short-term commercial paper. They do not mention repos, largely because of the difficulty of getting good repo data, according to lead author Viral Acharya.

The main purpose of the paper is to show that during the crisis 2007-2009 banks continued dividend payments even as they were struggling financially. Authors suspect the banks continued dividend payments because they didn’t want to spook their short-term lenders and because they thought taxpayers would bail them out if needed.

Dividend payments reduced the banks’ equity and amounted to paying shareholders, who included bank employees, at the expense of debt holders. This has increased banks’ cost of borrowing and may explain their reluctance to lend since the crisis, according to authors Acharya at New York University Stern School of Business, Irvind Gujral at London Business School, Nirupama Kulkarni at the University of California/Berkeley Haas School of Business, and Hyun Song Shin at Princeton University.

Interesting factoid from the paper: “The cumulative acknowledged credit losses for financial institutions worldwide since the beginning of the financial crisis in August 2007 to the end of 2009 were $1.73 trillion.”

From the paper “Dividends and bank capital in the financial crisis of 2007-2008”:

In the 2007-2009 period, all the banks (excluding the GSEs) which had received TARP funding had paid at least 45% of the amount as dividends in 2007-20009. JP Morgan, had paid out $12 billion dollars, almost half of the TARP funds it eventually received from the government. Similarly Bank of America and Citigroup which received $45 billion each in TARP funds had paid out $21 billion and $17 billion respectively in 2007-2009.

Most corporate debt has covenants which prevent banks from paying out dividends when negative earnings are reported. This constraint prevents firms from transfer of funds to equity holders at the expense of debt holders.

In contrast, banks have continued to pay out dividends even during the crisis. This can be attributed to the short-term nature of their funding and the implicit and explicit guarantees provided by the government. Banks are typically funded by short-term debt. As a result, if they were to announce a dividend cut, rollover debt can “run” as it did on investment banks. The fear of “runs” leads banks to continue paying dividends even when it would be prudent for them in the long-run to cut dividends.

Further banks benefit from the explicit and implicit guarantees provided by the government. The explicit government guarantees provided on deposits for commercial banks ensures that the banks are protected even in the event of a failure. Similarly, many financial institutions may have the implicit government guarantee for firms which are considered too-big-to-fail. Thus, banks are unlikely to cut dividends, figuring that in the event that they do fail, they would most likely be bailed out.