Monday, May 14, 2012

Defusing a Ticking Time Bomb

Why bankers like leverage—and what that could mean for the global financial system.

Debt, debt, and more debt. Four years after the financial crash of 2008, world banks continue to have enormous debts on their balance sheets, a time bomb that regulators, researchers, and bankers are still debating the best ways to defuse.

In mid-April, Moody’s, one of the most influential ratings agencies, downgraded 2 banks and warned 15 others that they are in danger of a downgrade because of their tendency to leverage their balance sheets; that is, load up on debt to a dangerous level.

Even absent a systemic crisis, a massive debt overhang, embedded debt that makes funding — especially with new equity — difficult and more expensive, affects borrowers from homeowners to governments. For banks, debt overhang might lead to a reduction in lending when they are distressed. In the worst case, the very survival of those institutions can be threatened, and governments may end up rescuing the largest ones at taxpayer expense, as happened in 2008. Given the continued distress of some banks in the United States and especially in Europe, how should this problem be dealt with both in the short run and to avoid future crises in the longer run?

The main effort on this front is the international agreement called Basel III, ratified by G-20 leaders but not yet fully implemented anywhere. Are the proposed reforms, including the various parts of the Dodd Frank Act in the United States, the best we can do to prevent a crisis and create a safe and healthy system? Not at all, says Anat Admati, a professor of finance at the Stanford Graduate School of Business. Deeply indebted banks still threaten the entire financial system. “The stakes are enormous. We want a banking system that serves the economy. There is no way for this system to do this if it is left alone because the incentives within the institutions —particularly those of their managers, with respect to how much risk they take, including through borrowing — are very different from what is good for the economy,” she says.

Bankers have resisted proposals to significantly reduce their reliance on debt to fund their investments. Why is this? That’s the question that Admati, in work with Peter M. DeMarzo and Paul Pfleiderer, both of the GSB, and Martin F. Hellwig of the Max Planck Institute for Research on Collective Goods in Bonn, addresses in earlier work and in the latest paper “Debt Overhang and Capital Regulation,” a March 2012 working paper.

In a previous paper, the same authors focused on the subsidies associated with debt, particularly for the banks that are considered “too big to fail.” These banks have almost blanket guarantees, which create severely perverse incentives with respect to risk taking. In the current paper, Admati and her coauthors focus on another effect that would create a resistance to reducing leverage even without such subsidies. The problem is a strong conflict of interest between the managers and shareholders and creditors (or indeed anyone guaranteeing the debt, as is the case for banks) regarding who bears the downside risk. Showing the great inefficiencies that this can create, the authors conclude: “Private actors in the banking system have strong incentives to choose excessive leverage that is not only unnecessary, but is harmful to the ability of the system to serve the economy.”

Why bankers like leverage

Banks typically borrow about 95% of the funds needed for investments. The increasing use of short-term debt instruments that must be paid back or renewed every few days makes the funding of banks particularly fragile. That’s because concerns about the bank's ability to repay can lead investors to refuse to renew the debt, explains Admati.

The debt could be reduced, but payouts in the form of huge bonuses and salaries for managers whose compensation is based on return-on-equity, unadjusted for risk, reward them for policies that increase leverage. Shareholders are willing to go along either because they don’t see the risks of thinly capitalized and therefore highly leveraged businesses to the rest of their holdings and the economy, or they also benefit from the government subsidies of debt, as well as from the dividends and share buybacks, says Admati.

The stream of money that is currently going to managers and shareholders could be used to reduce leverage or to pump money into the economy, but it isn’t. Like a bankrupt homeowner who won’t repair his roof, shareholders and bank managers see no direct benefit in paying off their creditors to reduce leverage, she says.

How could debt be reduced? “Pure recapitalization involves buying back debt using new equity, without changing the assets held by the bank. Alternatively, leverage can be reduced by selling assets and using the proceeds to buy back debt (“deleveraging”), or by issuing new equity and acquiring new assets,” according to the paper.

Reducing leverage, by any of these means, is costly to shareholders and managers since it transfers value from them to debt holders or taxpayers (or both) at a cost to existing shareholders, who would bear more of the downside risk if leverage is reduced. That effect can be seen in the decline of share prices when institutions reduce leverage. For “normal” companies, creditors worry about excessive risk taking and other inefficient decisions managers might take on behalf of shareholders that might harm them, and this is reflected in “debt covenants” that restrict what companies can do once they take on the debt, or in refusal to lend to a highly indebted borrower.

Banks seem able to continue to borrow because their creditors are not as concerned about their actions as they would have been without government safety net. This breaks down the natural mechanisms that prevent most companies from choosing to borrow as much as banks, even though they are not regulated to constrain their leverage. “The question is not why banks are not like Apple, which is funded entirely with equity, but why Apple or most other companies, choose to stay away from too much borrowing.”

Admati and her coauthors show that leverage is “addictive” to borrowers, and this effect is particularly strong for banks, where the natural process of market discipline does not work to limit borrowing. “A heavy borrower might choose to increase debt if they are able to do so, but would not choose to reduce it, even if this would be beneficial to the overall value of the firm,” explains Admati. “This shows that a lot of borrowing, especially by banks backed up by taxpayers, can create great inefficiencies for society. The key is to force a shift of more downside to the shareholders and managers of the banks, even if this is painful for them.”

The authors make a distinction between shareholders who are taxpayers and hold diversified portfolios that might include banks, and the managers whose bonuses and stock holdings are concentrated in the bank. For the managers, particularly given their compensation structure, reducing leverage is costly, but for the majority of the shareholders, it would be likely beneficial, because it would help prevent all the inefficiencies, and it would save taxpayers bearing excessive downside risk that can be very costly in a crisis. 

There has been a lot of concern about banks in Europe choosing to sell assets or reduce lending in response to increased capital requirements. The paper by Admati and her coauthors analyzes how the choice of adjustment method would be viewed by those who make the decisions. While some asset sales would not harm the economy, the authors suggest that if authorities are worried about inefficient reduction in lending, they could reduce the discretion banks have in the process of reducing leverage.

The most critical policy recommendation in this paper reinforces the prescription in the authors’ earlier work. The authors strongly recommend that regulators pay particular attention to payouts banks made to shareholders and managers that deplete the existing equity by distributing retained earnings rather than using them to invest and generally reduce indebtedness. Admati and her coauthors are very critical of the recent decision by the Federal Reserve to allow most large U.S. banks to make large payouts in the form of dividends and share buybacks. (They have also submitted a strong comment letter to the Fed on this topic recently.) By contrast, they praise the Bank of England Financial Policy Committee for pressing banks to pay bonuses using newly issued shares, without depleting existing earnings.

In all their writings, Admati, DeMarzo, Hellwig, and Pfleiderer come to the strong conclusion that the Basel III proposals are insufficient and flawed. They are also critical of the system of risk weights used in this regulation, which introduces further distortions and inefficiencies. They call for countries to go beyond the Basel III minimum and design better regulation that involves significantly higher equity requirements, more in the range of 20%, or even more equity relative to total assets, compared to the 3% Basel III allows.

For further information on this paper and other related writings, click here.