An Open Letter to Anat Admati Regarding Her Idiotic Open Letter to JPMorgan Chase Board of Directors:
Dear Prof. Admati:
I wonder if you’ve lost your mind. You seem to think that requiring banks to maintain capital levels of 20% or more will provide nearly certain protection against another financial panic, and at virtually no cost. That’s ridiculous on its face, and is even more ridiculous after one gives the idea a little thought.
To begin with, your assumption that equity capital is some kind of all-purpose cure-all for anything that might go wrong in the financial system is mistaken. In the midst of a full-blown panic, capital doesn’t count for much. As I explained on this very topic a few weeks back:
At the depths of a financial panic, it’s not inadequate capital that usually dooms banks, it’s inadequate liquidity. If you doubt it, let’s play a mind game. Let’s pretend it’s September 2008 again, you’re in charge of overnight lending at a large financial institution, and the fellow from Lehman Brothers is on the phone. . . . and Lehman’s equity ratio is a plump 20%. Would you provide Lehman with another day’s worth of funding?
Spare me the bravado; no, you would not. Why? Because in those panic-pitched days, no one had any idea what Lehman Brothers’ underlying assets were worth and, to be on safe side, people chose to assume the worst. Sixty cents on the dollar? Fifty cents? . . . The losses implied by those numbers would have swamped even the mightiest balance sheet. More important, even if you thought you had a handle on the matter (which you did not), you weren’t sure Lehman’s other lenders did, so that in the worst case, you’d provide the overnight funding while the others held back, and Lehman would blow up anyway, only with your money and nobody else’s. . . . .
Professor, you’re not the first academic to underestimate the role that raw emotion-fear-plays at times of financial stress. It can be overwhelming: if the minimum 20% capital requirement you advocate had been in place during the credit crunch, the dominoes would have fallen more or less the way they did.
You also argue that risk-minded equity investors would be willing to accept the lower returns that would inevitably emerge from a less-leveraged banking system. That, too, is mistaken. Again, put away your spreadsheets and look at the world around you. There’s a practical lower limit to the returns even the most risk-averse equity investors will accept. By all appearances, that limit appears to be 8%. Eight percent, at any rate, is the average ROE regulators allow electric utilities to earn. Utilities are the least-risky companies money can buy. These are companies, remember, that have little risk of insolvency or obsolescence, and whose earnings are essentially the result of government fiat. To the extent that’s practically possible, very little can go wrong-and still investors demand 8%. The notion that investors in banks (who even you are willing to let fund themselves 80% with debt) would be willing to accept something similar is preposterous.
What’s more, banks simply have no use for the added capital regulators have already forced them to take on. That capital, by the way, is substantial: since the depths of the panic, the banking system has added $440 billion in new capital. The average capital ratio has more than doubled, to 11% of risk-weighted assets, from 6% prior to 2010. But as I say, banks simply can’t earn an adequate return on that new money-which is why so many of them are scrambling to find ways to return it to shareholders as quickly and efficiently as they can, and returns have declined. As an alternative, I suppose banks might reach for return by financing especially risky projects. But that’s the sort of thing that got us into a mess to begin with.
One last point. You note in your letter to Morgan’s board that “JPM should advocate changes in the tax system to remove the advantage of debt over equity.” Really? Professor, JPMorgan Chase lends money for a living. Forget your cost-of-capital theories for a minute. Ending tax-deductibility of interest would be really bad for the banking business. Society may or may not be better off if interest weren’t tax deductible. But if Morgan’s board were to push the idea, it would be ignoring the interests of its own shareholders.
Little in your proposal to boost banks’ capital levels makes much sense. Any additional safety it would provide the banking system would be negligible, yet it would make credit scarcer and more expensive. Economic growth would slow and unemployment would rise. Presumably (and hopefully), Morgan’s board will ignore every word you have to say.
What do you think? Let me know!