The Bankers Who Cry Wolf

‘In recent years…a tension has emerged between reform and growth.  Regulators want to complete the reform in part by having banks hold substantially more capital, a goal which the financial industry supports.  Nonetheless, this vies with the broader aim of lifting growth by increasing available credit and bank lending.’

Axel Weber, Chairman of Swiss bank, UBS

Most people are familiar with Aesop’s tale of the boy who cried wolf.  A bored shepherd boy amuses himself by crying wolf when there is no wolf.  He does so twice and villagers come rushing to help each time, only to find that that there is no wolf.  When he cries wolf a third time, the villagers believing that he is lying to them once again, ignore him; only this time, a wolf has set upon and scattered the shepherd boy’s flock.

The chorus of bankers complaining about onerous capital requirements reminds Skeptikoi of Aesop’s tale.  Two banking and finance academics, Anat Admati and Martin Hellwing have recently published a book (The Bankers’ New Clothes) that exposes the myths surrounding bankers’ cries of wolf.  Given that excessive leverage amongst financial institutions propagated the financial crisis, Skeptikoi strongly recommends the book to anyone interested in the safety of the global financial system.

The bankers’ common cry is that they are forced to set aside regulatory capital, which sits idle on their balance sheet and could otherwise by lent to businesses and households.  The Chairman of Swiss investment bank UBS suggests that there is a trade-off between regulatory capital requirements and economic growth.  As seductive as this might sound, it is utter nonsense.

To understand why, it is important to consider the basic function of a bank as ‘maturity transformation’.  On the right side of a bank’s balance sheet are its liabilities: wholesale debt funding, customer deposits and common equity that it raises from shareholders.  A bank uses these funds to lend to businesses, households and governments.  The loans are a bank’s assets that obviously sit on the left side of its balance sheet.  There is a mismatch in maturity between the bank’s assets and liabilities; its assets are typically long term and illiquid.  There is no transparent price mechanism that reflects and conveys the market value of loans.  In contrast, a bank’s liabilities are short shorter term and liquid; for instance, customer deposits are either at call or have a term of up to three years, while funds borrowed from wholesale debt markets have a similar short maturity.

The key function of a bank is to manage the mismatch in maturity between its assets and liabilities.  It does so primarily by carefully evaluating prospective borrowers’ ability to make their loan repayments.  To this end, a bank might demand some form of collateral from the borrower.  A mortgagee has to pay a minimum deposit or down-payment, while banks typically impose debt covenants on business borrowers that allow the bank to re-negotiate the terms of the loan if those covenants are breached.

Capital regulation is concerned with a bank’s mix of liabilities.  In banking, capital refers to the amount of equity raised from shareholders and used to fund a bank’s lending activities.  Why would a prudential regulator wish to impose constraints on a bank’s funding or liability mix?  It gets back to a bank’s delicate task of managing the maturity mismatch between its long dated illiquid assets (ie. loans) and short-term liquid liabilities.  A bank that is heavily reliant on short-term funds borrowed from wholesale debt markets can easily become vulnerable to a crisis of confidence if a large enough number of business and housing loans it has written have defaulted.

Capital regulation simply forces banks to have a minimum amount of common equity (relative to total assets or risk weighted assets) in their liability mix.  A crisis of confidence is less likely if a bank has secured a larger share of its funding from equity or shareholder capital, which Admati and Hellwig describe as ‘un-borrowed money’.  As residual claimants to a bank’s cash flows, a bank can cease dividend payments to shareholders in the event that it gets into trouble.  Common equity acts as a buffer or shock absorber in the same way that a large deposit or down-payment better shields a mortgagee in the event that the value of her house declines.

Bankers continue to propagate the myth that that capital regulation constrains a bank’s ability to lend and inhibit credit growth.  Capital requirements do not require banks to set aside capital to sit idly in their vaults; the need to have a minimum amount of common equity in their funding mix does not affect the asset side of a bank’s balance sheet, notably its loans.  A bank retains complete discretion as to whom it lends to, and how much.

Even though five years have passed since the collapse of US investment bank, Lehman Brothers, banks’ capital ratios remain woefully inadequate.  Basel III has imposed more onerous capital requirements than its predecessors. Some national prudential regulators – including the Australian Prudential Regulatory Authority - have imposed  even higher capital ratios than recommended by Basel III.  Nonetheless, the leverage ratio (common equity to assets) for Australia’s major banks is typically no higher than 7%.  That is, for every $100 worth of loans written by a typical Australian bank, it holds only $7 of equity.  In contrast, the median leverage ratio for non-financial companies listed on the ASX200 is 50%!  The pattern of over-leveraged banks is similar for US and European banks, whose leverage ratios of around 10% are well below non-financials of 40%.

Banks that fund a greater share of their loans with common equity are safer and should be able to better withstand a run or a financial crisis.  Why then don’t banks hold more equity capital?  The answer is simple; taxpayer funded guarantees on deposits and systemically important banks encourage banks to take on excessive risk.  And government guarantees allow banks to borrow funds from wholesale debt markets at cheaper rates.  The lure of cheap debt funding is far too tempting for most bankers and trumps any systemic concerns that high leverage could undermine the stability of the financial system.

As long as governments and prudential regulators continue to heed bankers' cries of wolf on capital regulation, capital ratios will remain dangerously low.  Against ths backdrop, Skeptikoi believes that a crisis of confidence could once again expose the fragility of the global financial system.