By James Kwak
Update: See bottom of post.
For years now, Anat Admati has been leading the charge for higher capital requirements for banks, especially large banks that benefit from government subsidies, first in a widely cited paper and more recently in her book with Martin Hellwig, The Banker’s New Clothes. Admati’s great service has been clearing the underbrush of misunderstandings and half-truths so that it is possible to have a debate about the benefits of higher capital requirements. Yet even after all this work, the media (and, of course, the banking lobby) continue to repeat claims that are simply false or highly misleading.
In another effort to beat back the tides of ignorance, Admati and Hellwig have put out a new document, “The Parade of the Bankers’ New Clothes Continues,” which catalogs and addresses these claims. In the simply false category, the most common is probably that capital is “set aside”; in fact, banking capital is assets minus liabilities, and the capital requirement places no restrictions on what a bank can do with those assets.
In the highly misleading category is the claim that higher capital requirements would force banks to reduce their lending. Banks can respond to higher capital requirements by raising more equity capital or by reducing their balance sheets. As Admati and Hellwig write, “If increased equity requirements cause banks to reduce their lending, the reason is that they do not want to increase their equity.” (If they can’t sell new shares, then they have more fundamental problems and probably shouldn’t be in business.) And why don’t they want to increase their equity? Because executives have one-way compensation packages based on return on equity, which is not adjusted for risk, so they don’t want to increase the denominator.
As Admati and Hellwig no doubt realize, this is not a battle that is going to be won solely with truth, light, and logic. The banking lobby has a vested interest in sowing confusion, with masterpieces like the IIF’s “report” claiming that higher capital requirements would shrink the global economy by 3.2 percent. And as long as bankers say that such-and-such a regulation will hurt growth and kill jobs, they will get a hearing. Ultimately, it’s all about politics, which was roughly the message of 13 Bankers. (Which is another reason why, in the long run, the only things that matter are campaign finance reform and early childhood education.)
Update: Banks’ unwillingness to increase equity by selling shares (or by not doing buybacks and dividends) is not simply due to one-sided bonus packages tied to ROE. A perhaps more serious problem is that of debt overhang. In short, if a company already has a lot of debt and its solvency is in question, shareholders will be reluctant to put more equity into the firm. That new money would mainly provide greater security to creditors, increasing the value of the firm’s debt, without providing much benefit to equity holders. So in this case, it’s not just the bank’s managers who resist selling new shares; they are actually doing so in the interests of shareholders (but not society). (For much more, see this paper by Admati et al.).
There are two solutions to this problem. First, if the bank really is insolvent, it should be shut down. Second, if it isn’t, regulators could force the bank to retain its earnings rather than paying them out in dividends and buybacks; over time, that would increase the amount of equity in the firm. Creditors could also refuse to lend to a bank that is too highly leveraged—but in the case of systemically important banks, creditors don’t really care, because they know they will be bailed out in a crisis. (That is undeniable, even for people who think that managers and shareholders might not be bailed out.)