The Economist - Book Review

[johnkarls]

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The Economist – 4/13/2013

Safety In Numbers: An Important Argument For Safer Banks Is Undermined By Its Tone
By (unattributed)


NEARLY six years have passed since rumblings in the credit markets signalled the start of the financial crisis. Yet the debate over what ailed them and how best to fix them burns on as fiercely as ever.

One element of the diagnosis is relatively uncontroversial. The banks’ capital base was far too thin to protect them against the shocks in property markets that eventually eroded confidence in virtually all big banks in America and Europe. Yet the question of how much capital they should hold to prevent a recurrence is still strongly contested.

Many readers may feel their stomachs sink at the mention of capital ratios and systemic risk. But Anat Admati, a finance professor at Stanford University, and Martin Hellwig, a director at the Max Planck Institute for Research on Collective Goods, have done an admirable job in explaining how capital in the banking system works to absorb shocks, and how too little of it makes banks unstable. To do so they invented Kate, a hapless house-buyer and small-business owner. When Kate sets out to buy a house using mostly borrowed money, the deposit she puts down is a bit like the capital that a bank holds on its portfolio of assets. If Kate puts down a deposit of, say, 5%, and her home increases in value by 10%, she triples her money. If the house falls in value, even by as little as 5%, she loses everything. If Kate puts down a much bigger deposit, she stands to make a less spectacular return if prices rise, but is far less at risk of losing all if they fall.

The plain-spoken homily of Kate demystifies an important concept at the heart of banking. This has generated praise for the authors from, among others, Sir Mervyn King, outgoing governor of the Bank of England, and Sheila Bair, former chairman of the Federal Deposit Insurance Corporation. Yet in the book’s homespun simplicity, it adopts a shrill tone and then gallops past important and nuanced arguments that, if addressed, would have strengthened the authors’ contention that the banking system needs to hold a lot more capital than it does at the moment.

Start with tone. The authors argue that since the credit crunch “serious attempts to reform banking regulation have foundered” and that today’s banking system “is as dangerous and fragile as the system that brought us the recent crisis.” The rhetoric makes for a fine call to action, but does not recognise the fact that capital ratios have already significantly increased. Most large banks now have two to three times more capital buttressing their balance-sheets than they did a few years ago. More capital may still be needed, yet in its efforts to specify how much more the book is a disappointment.

The authors set out to refute many of the arguments that banks and their lobbyists advance in defence of current capital standards. Among these is the myth that capital is idle and could better be employed lending to businesses or households (it is, in fact, just another way of financing a loan). They also challenge the argument that higher capital comes at the expense of economic growth. Yet on a central question, whether capital is more costly than debt and leads to higher borrowing costs, they slip.

In their zeal for higher capital—they suggest ratios of 20-30%—the authors argue that it is no more expensive than the debt and deposits that form the rest of banks’ balance-sheets; that no one can make banks safer at no cost. If that were indeed the case then why not immediately insist banks hold more capital? Why stop at the 30% proposed by the authors? Why not demand that banks have capital ratios of 50% or even more?

There are costs and trade-offs. The first is the unequal tax treatment of debt and equity. Interest paid by corporations and banks is tax-deductible, whereas returns to shareholders through dividends or share buy-backs are not. The authors correctly point out that this inequality is not immutable. But without a wholesale revision of tax codes, equity capital will remain more expensive than debt.

Another cost relates to the role that banks play in turning short-term deposits into long-term mortgages. This provides an important social function. Savers want ready access to their cash but do not want to have to repay their mortgages at the whim of their bank. The more that a bank uses its own equity to fund its loans, the less it is able to do so using deposits and offer a return to savers who would rather deposit funds with a bank than buy shares in it. In refusing to see that there are costs and trade-offs to be made in assessing the right level of capital, they weaken an important call to make the banking system safer.