I’m sure there’s a lot to admire about Anat Admati, the Stanford economics professor lately pushing regulators to force banks to add massive amounts of new equity to their balance sheets. But you especially have to stand in awe of her chutzpah. Here’s a woman with no particular expertise in the banking industry (the Times says that, before the credit crunch, she specialized in “complicated financial models”), who’s decided she suddenly knows enough now to recommend radical changes a 500-year-old industry that worked well enough the old way that it managed to play a central role in financing the rise of Western prosperity. All these centuries, and it turns out bankers were doing it wrong. Who knew?
In particular, Admati says banks are too highly levered. In order to better to absorb credit losses, banks’ balance sheets should consist of something like 30% equity, she says, compared to just 5% now. (I’m not sure how she comes up with that latter number; the capital ratios regulators look at are considerably higher.) If banks had been thus capitalized prior to the housing blowup, Admati argues, the resulting credit crunch wouldn’t have happened at all, or would have been much less severe. She’d have banks get to her equity target by restricting dividend payments to shareholders entirely until it was met.
It all sounds very sensible—except that Admati’s scheme would be a disaster, for a variety of reasons. The first has to do with arithmetic. As it is, in the current post-Dodd-Frank environment, the typical ROE at a big bank is around 11%, or not much higher than the typical investor’s cost of capital. That’s with equity at 5% of assets. Now do the math. Boost that 5% to 30% (and tell shareholders they won’t be getting any dividends for the next several years, by the way) and banks’ ROEs would fall to the low single digits. Capital would flee the industry—the very opposite outcome Admati presumably wants. Alternatively, banks might try to boost returns by writing riskier loans. But that would invite the heightened credit losses that have gotten Admati so exercised in the first place. Or banks could raise the cost borrowing. But that would drive more borrowers to the (unregulated) shadow banking system. I somehow doubt that‘s the outcome Admati has in mind.
As I say, a disaster. Nor would Admati’s 30% solution, had it been in place when the housing market blew up, have necessarily prevented the credit crunch that followed. Do you remember what people were thinking during those dark days? The subprime mortgage meltdown was only going to be the beginning, they warned. The consumer borrower was in extremis: after mortgages, the credit quality of auto loans would soon collapse and, after that, credit card loans. It would add up to a massive credit collapse. Commercial real estate would be next and then, who knows? At such a level of uncertainty, no one could know for sure exactly what a given bank’s assets were worth. In the very worst case (which at the time was the only case that providers of overnight funding seemed willing to consider) even a 30% haircut might not be enough. Fear can be funny that way. So that hypothetical 30% equity cushion very likely wouldn’t have prevented the panic from happening.
Admati may not like it, but by its nature, the banking business involves lots of leverage. Deposits are liabilities, remember, and deposit-gathering is a core banking activity. You can argue, and I’ll agree with you, that by the mid-2000s bankers (led by the Robert Rubins of the world) became so lulled by their newly invented imaginary skills at “better managing balance sheet and credit risk” that they operated at levels of leverage that, in retrospect, were plainly too high. But since then, the business has added massive amounts of new capital—to the point that it’s having trouble putting it all to profitable use and is searching for ways to efficiently return capital to shareholders.
Admati seems to want to prevent the possibility of another banking crisis, but that’s the wrong goal. Profitable lending has to entail risk–and as long as there’s risk (and human emotion) there’s going to be the possibility of an institution failing. It’s called free enterprise. What Admati ought to be worrying about, then, is figuring out a way to let a single large institution fail without engulfing the entire system in a panic, and without involving taxpayers. That would solve the problem Admati wants to fix. Boosting equity levels through the roof though wouldn’t fix anything–and would instead drive the banking industry straight into the ground.
What do you think? Let me know!