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Too little bank capital forces taxpayers to act as equity

March 28 2013 1 comment

Euromoney is bizarrely adamant that British banks should have as little capital as possible.

“It’s all too easy to be seduced into fear over the capital positions of UK banks,” it rightly says, while clearly resisting the temptation itself. Indeed, Euromoney isn’t worried at all. It seems to think that a vague 7% equity buffer is more than enough capital to protect taxpayers from ever having to foot another bail-out — or perhaps it just doesn’t care.

As long as bank investors earn a return for risking none of their capital and bankers get overpaid on the subsidised spread, all is for the best in the best of all possible worlds. Though it’s unclear what journalists get from the deal. Free banker love?

The situation is much simpler than is often portrayed in the press, as described in a book called The Bankers’ New Clothes by Anat Admati and Martin Hellwig, which does an excellent job of explaining why banks should fund themselves with a lot more equity, just as every other type of company on the planet does.

Admati and Hellwig have done the research (published in previous academic papers), and it shows that the funding mix a business chooses — the ratio of debt and equity — has little to no effect on its operations.

Bankers often make it seem as though equity is somehow set aside for a rainy day and thereby restricts their lending ability, but this is nonsense. Beware bankers whose lips move. The difference between equity and debt is that equity doesn’t have to be repaid. The proceeds from both end up in the same pot.

Because debt has to be paid back, businesses that are too dependent on it can quickly become swamped if the value of their assets depreciates. And this is as true for Citi as it is for Apple (which has almost zero debt).

To put that in terms that all homeowners will understand: the financial crisis caused the banks to fall into negative equity because they were mortgaged to the hilt. And the response to the crisis has only made things worse — they continue to be heavily mortgaged because their borrowing costs are so cheap due to an implied taxpayer guarantee through too-big-to-fail.

The only beneficiaries of this are the bankers and the investors. It makes no positive difference to bank customers or to the financial system. In effect, taxpayers are the equity.

Needless to say, this is not an efficient way to run the financial system. The discipline imposed by funding with equity is almost completely removed, yet the safety cushion is still in place thanks to the captive equity unwittingly provided by taxpayers.

This blatant moral hazard is cause for celebration over at Euromoney: “Importantly, there is no trigger for any fresh equity issuance, with a new recommended end-2013 capital target of ‘7% of RWAs’.”

Hurrah! That’s a 93% mortgage on the entire banking system — assuming that the banks don’t cheat, which they obviously do.

Does anyone outside The City think that’s a prudent margin of safety for the most important sector of our economy? Seven percent. Would people be surprised to find out that their home enjoys more secure funding than the bank that’s providing it? I think so.

When it comes to the national economy, politicians love to draw comparisons with small businesses and households and common-sense notions of thrift. But what happens to those sentiments when it comes to discussing the banks? The plain wisdom of the greengrocer is quickly forgotten and, instead, we’re treated to mind-boggling banker gibberish that is ultimately a lesson in the benefits of maximum leverage.

Given the level of deliberate obfuscation, it’s perhaps not surprising that some people misinterpret what’s really being said. “Equity is expensive,” they wail, as if bank investors are somehow a different breed of animal to the people buying Apple stock. They are not, of course.

Bank equity is only expensive when compared to taxpayer-subsidised bank debt, but the cost of that subsidy is very real. Bankers can safely ignore those costs because they’re not on the banks’ balance sheets, but from a national perspective it doesn’t make any sense to say that bank equity is expensive — because the nation does bear the cost of guaranteeing the debt.

So, the question is really about choosing a capital structure that maximises the safety and the utility of the banking system, rather than the current arrangement that simply maximises compensation for the bankers themselves.

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