Anat Admati, professor of finance and economics at Stanford University’s Graduate School of Business explains how to prevent another meltdown from taking place in the U.S. banking sector.
The big question: Are we at risk of another banking crisis?
Oh, yes. Definitely. We continue to have a system that’s way more prone to crisis than it needs to be.
Why are we still vulnerable?
Banks continue to be much too highly indebted and interconnected. That means they all tend to get in trouble at the same time, and the failure of one can take down others. It creates a contagion that spreads through the economy.
As with speeding, everything is fine as long as you don’t have an accident. When you have an accident, others can get harmed.
In your new book, The Bankers’ New Clothes, you and co-author Martin Hellwig say one simple, radical move can help. What is it?
You need to reduce dramatically banks’ indebtedness and increase dramatically the reliance on equity funding. This would make it less likely that the banks get into trouble, need bailouts, or drag down the economy.
So what’s equity funding, in practical terms?
It’s like the equity in your home, which is what you would have after selling the house and paying your mortgage. In accounting, it is the value of assets minus debts or liabilities.
For banks, one kind of debt is your deposits: A bank borrows your money to make loans or other investments. Its equity funding is money that is not borrowed from depositors or other sources, but instead comes from stock sales or retained earnings.
Why do banks borrow so much money instead of selling stock?
Banks, like all corporations, get a tax break on their interest payments, just like your mortgage deduction. But that’s not the only way that we subsidize and encourage banks’ borrowing and risk taking.
What do you mean?
People lend to banks at low rates because the banks have Uncle Sam or the FDIC to catch them if they fail. Large banks are not paying for the implicit guarantee to their creditors that the government will bail them out if something goes wrong.
How do you propose banks go about increasing their equity?
The easiest and most straightforward way is to avoid paying cash out to shareholders in dividends. Banks should retain their earnings just like Warren Buffett does. Publicly traded companies can raise more equity by selling more shares.
Wouldn’t shareholders object? Our readers love dividends.
The people who really benefit from bank dividends are bankers or people whose wealth is concentrated in banks. You and I are diversified shareholders. Any happiness you feel when banks pay dividends is shortsighted, because the payments harm the economy by making banks more fragile. And in a financial crisis, a diversified portfolio suffers.
Once banks build up enough equity, they can resume paying dividends.
Banks have rejected calls for increased equity. They say these higher capital requirements will reduce the amount of money they can lend. True?
No! Equity is just like debt: a source of funds for banks’ loans and other investments. If banks retain their earnings or sell more stock, they can use the money to make more loans.
They’ve also argued that it will hurt shareholders by cutting their return on equity — a bank’s profits as a percentage of its equity.
The focus on ROE may have more to do with bankers’ compensation than with shareholders’ wishes, since ROE is often used to calculate bonuses. ROE may fall if a bank uses more equity, but risks will be lower too, so shareholders would require less of a return.
How much equity are banks required to have now?
U.S. rules let banks have as little as 3% to 4% of their total assets as equity. The rest they can borrow.
How much equity do you think banks should have to be safe?
I think 20% to 30% of total assets is appropriate.
That’s quite a jump. Why so high?
Having more equity makes for better lending decisions. Highly indebted banks avoid making boring but productive business loans, because there is not enough upside. It is similar to how a homeowner who has little or no equity left in a house doesn’t put in new windows, because any investment in the house benefits the lender, especially if the homeowner owes more on the mortgage than the house is worth.
Banks funded with more equity will be able to make loans more consistently and they will make better lending decisions that would help the economy.
What do you think, realistically, can actually get done to improve the banking system?
A bipartisan partnership, Sen. Sherrod Brown (D-Ohio) and Sen. David Vitter (R-La.), is pushing a proposal similar to mine: It would require 15% equity for the six largest U.S. banks. This is a sensible, cost-effective measure that would correct enormous distortions. The politics of it are very daunting, and there will be a lot of lobbying. The battle has not seriously begun.
Would it help to make banks keep more money in their vaults?
I’m talking about how banks get their money, whether it’s through borrowing or other means. What you’re talking about are reserve requirements, which limit how banks can use their money. Unless reserve requirements are very high, they don’t reduce banks’ fragility.
Let’s say a bank has $100 in assets, and $10 of that is sitting in the form of cash reserves, earning little or no interest. If the bank invests the other $90 in risky derivatives and loses $20, the bank may not be able to pay its creditors, and will go underwater. Having that $10 on hand won’t keep it solvent.
How is your proposal different from the Dodd-Frank reforms that, for example, give the FDIC the right to take over institutions if their troubles threaten the financial system, as Lehman Brothers did?
Dodd-Frank gave regulators much greater authority. Unfortunately, it was regulators who allowed risks to grow before the crisis, and they still are not protecting us. The Federal Reserve, for example, lets banks pay dividends based on flawed stress tests.
The investigation of J.P. Morgan Chase’s $6 billion derivative loss in 2012 reveals poor risk controls. And Attorney General Eric Holder has said some banks are still too big to prosecute. These are clear indications that something is really wrong.