Free Exchange: Capital punishment
Sep 14th 2013 |From the print edition
IN THE five years since Lehman Brothers failed, proposals to make the financial system safer have proliferated. One of the few on which there is widespread agreement is that banks should be less leveraged—in other words, that they should fund themselves more with equity and less with debt. This means a given loss would be less likely to render a bank insolvent. But a new paper casts leverage in a far more flattering light: it is necessary to meet the public’s demand for money-like assets.
This perspective is largely missing from the debate on just how much extra equity banks should hold. Bankers argue that equity is dearer than debt. Requiring them to issue more of it forces them to charge more on loans, hurting economic growth. Rubbish, critics respond. As Franco Modigliani and Merton Miller noted in 1958, other things being equal, the value of an enterprise does not depend on its mix of debt and equity. If a bank issues more equity, it will be less likely to go bankrupt. Its equity should be safer as a result, and therefore cheaper. Forcing banks to reduce their leverage also has the advantage of neutralising the subsidies that banks receive—deposit insurance and the implicit promise that any bank deemed too big to fail will be bailed out.
Less bank leverage is not unambiguously good, however. Banks are useful not just because they make loans but also because they issue debt in a form that is extremely handy to the people that fund them. Like money, bank deposits are highly liquid, a store of value, convenient for settling transactions, and require no due diligence. The price of this convenience is that households get less interest on their deposits than on bonds, a spread known as the “liquidity premium”.
In a new paper Harry DeAngelo of the University of Southern California and René Stulz of Ohio State University show that this premium means that banks, unlike other firms, are not indifferent to leverage, as the Modigliani-Merton theorem suggests. Mr DeAngelo and Mr Stulz show that it is better for banks to be highly levered even without frictions like deposit insurance and implicit guarantees. Banks would still choose to be levered because the liquidity premium lets them borrow cheaply.
Their model can explain a historical curiosity. Banks’ capital ratios have fallen steadily over the past two centuries. This has often been attributed to the introduction of deposit insurance and the role of lenders of last resort, which reduced the cost of bank debt. But in America’s case much of the drop in borrowing costs came before the creation of the Federal Reserve in 1913 and the introduction of federal deposit insurance in 1933. An alternative explanation is that as banking became more competitive, lenders were forced to offer better terms to depositors, narrowing the liquidity premium. The model of Messrs DeAngelo and Stulz shows that as the liquidity premium shrinks, banks must crank up their leverage to compensate.
If leverage meets the demand of borrowers for a safe, money-like investment, forcing banks to reduce their leverage may have nasty side-effects. Imagine a bank that, instead of issuing $9 in deposits and $1 in equity, issues $8 in deposits and $2 in equity. One option is for the public to hold $1 less in deposits and $1 more in equity, thereby assuming more risk than it would prefer. More likely, “shadow banks” (institutions that act like banks but are not regulated like them) would step in to meet the public’s unmet demand for money-like assets. As shadow banks take over some of the banks’ responsibility for producing money-like assets, the financial system becomes more fragile.
Another paper by Gary Gorton, Stefan Lewellen and Andrew Metrick, all of Yale University, finds that although the volume of financial assets in America has grown dramatically since 1952, the proportion they consider safe has remained at around 33%. But the mix of these safe assets has shifted from government debt and bank deposits towards “quasi-safe” shadow-banking debt: commercial paper, “repo” loans and money-market funds.
Even before the crisis, restrictions on leverage played a part in this shift. Banks sought to conserve their capital by moving mortgage-backed securities to off-balance-sheet vehicles, financed with short-term paper. Investment banks financed their mortgage holdings with repo loans. Investors treated these IOUs as money, giving little thought to the collateral they received. When the mortgage market collapsed, what investors thought were riskless, liquid assets turned out to be risky and illiquid.
Five years since Reserve Primary, too
The push for lower leverage since the crisis has yet to spawn similar side-effects because banks have been chasing deposits to replace wholesale funding. But in time, more equity could constrain banks’ capacity to supply people with money-like assets, pushing them into the arms of shadow banks. Hence regulators’ continued worries about money-market funds. Such funds try to maintain a constant $1 per share net asset value, which encourages investors to treat them as cash. Technically, though, they are equity investments: funds can pay out less than a dollar. That’s what the Reserve Primary Fund did when its holdings of Lehman paper went bad, sparking a broader run on money-market funds.
The European Commission has proposed compelling money funds to have a predefined capital buffer. America’s Securities and Exchange Commission is calling on funds either to float their share prices or limit withdrawals during times of stress. Both want investors to stop treating investments in money-market funds as money. A laudable goal, but one with its own downside: investors may head off in search of another money-like asset in another penumbral corner of the system.
“Why High Leverage is Optimal for Banks”, by Harry DeAngelo, University of Southern California, and Rene M. Stulz, Ohio State University, NBER & European Corporate Governance Institute Working Paper, August 2013
“The Safe-Asset Share”, Gary Gorton, Stefan Lewellen and Andrew Metrick, Yale School of Management, National Bureau of Economic Research Working Paper, January 2012
“The Cost of Capital, Corporation Finance and the Theory of Investment”, by Franco Modigliani and Merton Miller, The American Economic Review, June 1958
“Do the M & M propositions apply to banks?”, by Merton Miller, Journal of Banking & Finance, 1995
“Misunderstanding Financial Crises”, by Gary Gorton, Oxford University Press, 2012
“The Bankers’ New Clothes”, by Anat Admati and Martin Hellwig, Princeton University Press, 2013
The original article is linked here.