Tuesday, November 9, 2010

Healthy Banking System is the Goal, not Profitable Banks

Text of Letter Published in Financial Times

(View the letter as it appeared in the Financial Times)

November 9, 2010

The Basel III bank-regulation proposals that G20 leaders will discuss fail to eliminate key structural flaws in the current system. Banks’ high leverage, and the resulting fragility and systemic risk, contributed to the near collapse of the financial system. Basel III is far from sufficient to protect the system from recurring crises. If a much larger fraction, at least 15%, of banks’ total, non-risk-weighted, assets were funded by equity, the social benefits would be substantial. And the social costs would be minimal, if any.

Some claim that requiring more equity lowers the banks’ return on equity and increases their overall funding costs. This claim reflects a basic fallacy. Using more equity changes how risk and reward are divided between equity holders and debt holders, but does not by itself affect funding costs.

Tax codes that provide advantages to debt financing over equity encourage banks to borrow too much. It is paradoxical to subsidize debt that generates systemic risk and then regulate to try to limit debt. Debt and equity should at least compete on even terms.

Proposals to impose a bank tax to pay for guarantees are problematic. High leverage encourages excessive risk taking and any guarantees exacerbate this problem. If banks use significantly more equity funding, there will be less risk taking at the expense of creditors or governments.

Debt that converts to equity, so-called “contingent capital,” is complex to design and tricky to implement. Increasing equity requirements is simpler and more effective.

The Basel Accords determine required equity levels through a system of risk weights. This system encourages “innovations” to economize on equity, which undermine capital regulation and often add to systemic risk. The proliferation of synthetic AAA securities before the crisis is an example.

Bankers warn that increased equity requirements would restrict lending and impede growth. These warnings are misplaced. First, it is easier for better-capitalized banks, with fewer prior debt commitments hanging over them, to raise funds for new loans. Second, removing biases created by the current risk-weighting system that favor marketable securities would increase banks’ incentives to fund traditional loans. Third, the recent subprime-mortgage experience shows that some lending can be bad for welfare and growth. Lending decisions would be improved by higher and more appropriate equity requirements.

If handled properly, the transition to much higher equity requirements can be implemented quickly and would not have adverse effects on the economy. Temporarily restricting bank dividends is an obvious place to start.

Many bankers oppose increased equity requirements, possibly because of a vested interest in the current systems of subsidies and compensation. But the policy goal must be a healthier banking system, rather than high returns for banks’ shareholders and managers, with taxpayers picking up losses and economies suffering the fallout.

Ensuring that banks are funded with significantly more equity should be a key element of effective bank regulatory reform. Much more equity funding would permit banks to perform all their useful functions and support growth without endangering the financial system by systemic fragility. It would give banks incentives to take better account of risks they take and reduce their incentives to game the system. And it would sharply reduce the likelihood of crises.

SIGNATORIES TO THE LETTER IN THE FINANCIAL TIMES

Anat R. Admati George C. Parker Professor of Finance and Economics Stanford Graduate School of Business

Franklin Allen Nippon Life Professor of Finance Professor of Economics Co-Director, Financial Institutions Center The Wharton School, University of Pennsylvania

Richard Brealey Emeritus Professor of Finance London Business School

Michael Brennan Professor Emeritus, Finance Anderson School of Management, UCLA

Markus K. Brunnermeier Edwards S. Sanford Professor of Economics Princeton University

Arnoud Boot Professor and Director Amsterdam Center for Law & Economics University of Amsterdam

John H. Cochrane AQR Capital Management Professor of Finance University of Chicago Booth School of Business

Peter M. DeMarzo, Mizuho Financial Group Professor of Finance , Stanford Graduate School of Business

Eugene F. Fama Roger R. McCormick Distinguished Service Professor of Finance University of Chicago Booth School of Business

Michael Fishman Norman Strunk Professor of Financial Institutions Kellogg School of Management, Northwestern University

Charles Goodhart Professor, Financial Markets Group London School of Economics

Martin F. Hellwig Director Max Planck Institute for Research on Collective Goods, Bonn

Hayne Leland Professor of the Graduate School, Haas Finance Group Haas School of Business, UC Berkeley

Stewart C. Myers Robert C. Merton Professor of Financial Economics Sloan School of Management, MIT

Paul Pfleiderer C.O.G. Miller Distinguished Professor of Finance Stanford Graduate School of Business

Jean Charles Rochet SFI Professor of Banking Swiss Banking Institute, University of Zurich

Stephen A. Ross Franco Modigliani Professor of Financial Economics Sloan School of Management, MIT

William F. Sharpe The STANCO 25 Professor of Finance, Emeritus Stanford Graduate School of Business (Nobel Laureate, 1990)

Chester S. Spatt, Pamela R. and Kenneth B. Dunn Professor of Finance; Director, Center for Financial Markets Tepper School of Business, Carnegie Mellon University

Anjan Thakor John E. Simon Professor of Finance Olin School of Business, Washington University