The Road to Hell is Paved with Good Intentions!

?“A govt that robs Peter to pay Paul can always depend on the support of Paul.” …George Bernard Shaw.

The key outputs of a bank— its product— are debt contracts, in the form of IOUs payable to the bank. The major inputs are also contracts….IOUs payable to depositors. Any institution whose inputs and outputs mainly comprise of promises to repay debts is inherently unstable.

Banks perform a tough balancing act: they borrow money from depositors and lend to debtors, but they cannot predict with certainty that even the most honest borrower will repay the loan. Also, it’s very difficult for bankers to precisely match the durations of their contracts with depositors and debtors. Even if their banks aren’t insolvent, panicky depositors might show up en masse to withdraw their money, and there might not be enough cash to meet those demands. The solution to this credit risk and liquidity risk is to create cushions in the B/sheet:

• The 1st is equity capital, money that’s invested in the bank by shareholders. This enables the bank to repay deposits in full even if some debtors fail to repay their loans.
• The 2nd is cash assets. Banks don’t lend out every penny they have; they hold some money in reserve.

The larger the bank, the larger the capital and cash cushions it requires to prudently operate. So long as depositors and providers of equity capital are willing to fund the bank, and the banker maintains sufficient capital and cash buffers, the banker can continue a safe, sound, and profitable business.

But this is easier said than done. As Nobel winner Robert Lucas put it, "a fractional reserve banking system will always be fragile, a house of cards".

How did it happen that in 1990 a mortgage applicant needed a 20% down payment, a good credit rating, and a verifiable employment and income history to obtain a low risk, 30-yr fixed-rate mortgage, but by 2003 could obtain a high-risk, negatively amortizing adjustable-rate mortgage by offering only a 3% down payment and simply stating their income and employment history, with no independent verification?

Politics is the answer!

The subprime crisis was the outcome of a political bargain between two unlikely partners: rapidly growing GSIBs and groups promoting risky mortgage lending to sub-prime borrowers, as revealed by a June 2002 trip that Bush made to Atlanta to unveil his “blueprint for the American Dream”. There he announced the goal of raising the no of minority homeowners by 5.5m by 2010. The power of politics is precisely the power to get a public official to go along with something that he knows is in the public interest becoz it is in his own short-term interest. The costs that society would bear are? long in the future, while the benefits of acquiescing are instant.

If housing policies were the fuel for the 2008 crisis, lax regulation was the hot, dry breeze that turned that fuel immensely flammable. The Fed monetary policy that shifted the incentives of home buyers to take even greater risks and the policymakers delegating the work of regulation to the ratings agencies amounted to two more logs thrown on the fire!

In 2014, Mark Carney, the then FSB Chair announced with great fanfare that an agreement on the new rules for the 30 most complex GSIBs would prevent bailouts in the future. FINMA announces on its website: “Financial mkt participants can become so large at a national and even int’l level that their disorderly failure could undermine financial stability and force a govt bailout. Following the 2008 crisis, the ‘too big to fail’ problem was addressed both in Switzerland and abroad.”

Note the claim: “the problem was addressed.” Many believed these words!

The confidence in these statements stands in stark contrast to the real events of March 2023. When faced with a run on Credit Suisse, the Swiss authorities, incl FINMA, didn’t use the new rules that had been developed to deal with distressed banks. Instead they engineered a bailout…a takeover by UBS, with liquidity support from SNB guaranteed by the govt for up to CHF 100bn and with a govt guarantee of up to CHF 9bn against certain losses.

So much for the promise that bailouts were history!

Whatever they say in public, most politicians prefer bailouts to anything else becoz they fear the collateral damage of a failing bank. They are loath to imposing losses on anyone, esp on folks whose votes (or monetary support) they will need in the next election.

Prudent banks insist on borrowers having “skin in the game” when they lend, yet strongly resist regulations that reduce their risky reliance on borrowing. Banks’ aversion to equity funding and addiction to borrowing enables them to shift costs and risks to others, eventually gaining at public expense. They often get away with it by keeping politicians and the public confused.

Is equity really expensive?

• As Stanford Prof Anati Admati argues, the view that it’s costlier to use equity funding than to fund by borrowing is sometimes justified by the observation that for each $ they invest in a bank's shares, shareholders “require” a higher return than debt holders. So if regulation forces banks to fund their investments with more equity, this view holds, their costs will increase forcing them to charge their clients higher interest on loans.?The argument is flawed. The statement that “the required return on equity is higher than the cost of debt” applies to all firms, not just to banks, and there is no regulation constraining how most firms fund their investments. Yet there are very few companies that rely so much on borrowing and use so little equity as banks. Is there something special about banks that makes equity expensive for them while for other firms equity is somehow cheaper?
• The claim that “equity is expensive becoz shareholders require higher returns than debt holders” has 2 basic flaws: (1) The reqd rates of return for debt and equity for a firm aren’t fixed but rather depend on the risk related to the firm’s investments. (2) The costs of debt and equity cannot correctly be considered separately and in isolation, without referring to the debt/equity mix that is deployed.?When there is more debt in the funding mix and thus more leverage, the risk to shareholders per $ invested is greater. Since they bear more risk, they ask for higher returns as compensation. In other words, the reqd ROE will be lower when there is more equity and less debt in the mix and higher if the funding involves less equity and more debt.

Yogi Berra remarked “You better cut the pizza in 4 pieces since I'm not hungry enough to eat 6.” That’s absurd but when banks borrow excessively and economize on equity, the total “pie” available to their investors grows. The more banks borrow, the larger the subsidies, as if more cheese were added when the pizza was cut into more slices! How?

• Banks and their creditors benefit from explicit and implicit govt guarantees. Depositors are protected by deposit insurance, which is guaranteed by the taxpayers. Other creditors, and even the bank’s shareholders, benefit if the govt provides addtl equity to prevent the bank from going bust—say, in a crisis.?Becoz depositors and other creditors rely on this support, they are willing to lend to banks on cheaper terms. Banks that benefit from implicit guarantees are given higher credit ratings, and thus pay less interest when they borrow. In 2014, IMF attached numbers to this advantage: $50bn for banks in US and Switzerland, $110bn in Japan and UK, and $300bn in the EU. This increases the amount of total pie available to their investors. Thus, taxpayers subsidize bank borrowing and these subsidies encourage banks to be more fragile.
• Apart from the incentives to economize on equity thanks to guarantees, borrowing is encouraged by the tax systems of most countries. In US, the interest paid on mortgages is tax deductible. If more debt is used relative to equity, any firm may be able to pay less in taxes to the govt, which allows investors to share more returns in total than they would have shared if their firm hadn’t borrowed at all. In summary, the part of the pie available to investors grows with more borrowing. A tax code that subsidizes debt and penalizes equity contributes directly to financial fragility.

In an industry competing intensely for growth, guarantees encourage recklessness and are a burden on taxpayers. If the banks’ creditors expect their investments to be safe becoz of the guarantees, they rarely pay attention to the risks the banks take.?

Public discourse in banking and finance is made difficult by the fact that many issues are complex and technical. Media deals with financial reforms at a superficial level. Also, in most countries they have political loyalties that bias their reporting. Explaining these intricacies to non-expert readers may require more space and effort than are available. So simple messages win! Prominence of a bank boss or a govt official may be more important than the substance of what they say.

In any sport, we assume that the umpires are not partial to one of the teams and that they enforce the rules as best as they can. By contrast, the WSJ report seems to suggest that perhaps the Basel 3 authorities are too much beholden to some of the privileged and powerful players and so shy away from full enforcement of rules.

G.B. Shaw remarked, “The reasonable man adapts himself to the world; the unreasonable man persists in trying to adapt the world to himself. Therefore all progress depends on the unreasonable man.”? Effective banking reform depends on informed and stubborn unreasonableness.??

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