The Bankers’ New Clothes: Arguments for simpler capital and much reduced leverage

It always pays to make sure you expose yourself to the opposite view. This post looks at some of the arguments for simpler and higher bank capital requirements put forward by Professors Admati and Hellwig. They have published a number of papers and a book on the topic but this post refers chiefly to their book “The Bankers’ New Clothes” and to a paper ‘The Parade of the Banker’s New Clothes Continues: 31 Flawed Claims Debunked”. As I understand it, the key elements of their argument are that:

  • Banks are inherently risky businesses,
  • Excessive borrowing by banks increases their inherent riskiness, but
  • Banks are only able to maintain this excessive level of borrowing because
    • Flawed risk based capital models underestimate the true capital requirements of the business
    • Market discipline also allows excessive borrowing because it is assumed that the government will bail out banks if the situation turns out badly

They identify a variety of ways of dealing with the problem of excessive leverage (controls on bank lending, liquidity requirements and capital requirements) but argue that substantially more common equity is the best solution because:

  • It directly reduces the probability that a bank will fail (i.e. all other things being equal, more common equity reduces the risk of insolvency),
  • A higher level of solvency protection has the added benefit of also reducing the risk of illiquidity, and
  • Contrary to claims by the banking industry, there is no net cost to society in holding more common equity because the dilution in ROE will be offset by a decline in the required return on equity

They concede that there will be some cost associated with unwinding the Too Big To Fail (TBTF) benefit that large banks currently enjoy on both the amount banks can borrow and on the cost of that funding but argue there is still no net cost to society in unwinding this undeserved subsidy. The book, in particular, gets glowing reviews for offering a compelling case for requiring banks to operate with much lower levels of leverage and for pointing out the folly of risk based capital requirements.

There are a number of areas where I find myself in agreement with the points they argue but I can’t make the leap to accept their conclusion that much a higher capital requirement based on a simple leverage ratio calculation is the best solution. I have written this post to help me think through the challenges they offer my beliefs about how banks should be capitalised.

It is useful, I think, to first set out the areas where we (well me at least) might agree in principle with what they say; i.e.

  • Financial crises clearly do impose significant costs on society and excessive borrowing does tend to make a financial system fragile (the trick is to agree what is “excessive”)
  • Better regulation and supervision have a role to play in minimising the risk of bank failure (i.e. market discipline alone is probably not enough)
  • Public policy should consider all costs, not just those of the banking industry
  • All balance sheets embody a trade-off between enterprise risk, return and leverage (i.e. increasing leverage does increase risk)

It is less clear however that:

  • The economics of bank financing are subject to exactly the same rules as that which apply to non-financial companies (i.e. rather than asserting that banks should be compared with non-financial companies, it is important to understand how banks are different)
  • A policy of zero failure for banks is necessarily the right one, or indeed even achievable (i.e. would it be better to engineer ways in which banks can fail without dragging the economy down with them)
  • Fail safe mechanisms, such as the bail in of pre-positioned liabilities, have no prospect of working as intended
  • The assertion that “most” of the new regulation intended to make banks safer and easier to resolve has been “rejected, diluted or delayed” is a valid assessment of what has actually happened under Basel III
  • That liquidity events requiring lender of last resort support from the central bank are always a solvency problem

Drawing on some previous posts dealing with these issues (see here, here and here), I propose to focus on the following questions:

  • How does the cost of bank financing respond to changes in leverage?
  • Are the risk based capital requirements as fundamentally flawed as the authors claim?
  • Are risk management incentives for bankers always better when they are required to hold increasing levels of common equity?
  • Do the increased loss absorption features of Basel III compliant hybrids (in particular, the power to trigger conversion or bail in of the instruments) offer a way to impose losses on failed banks without disrupting the economy or requiring public support

How does leverage affect the cost of bank financing?

Increasing the proportion of equity funding, the authors argue, reduces the risk that shareholders are exposed to because each dollar of equity they have invested

“ will be affected less intensely by the uncertainty associated with the investments”

“when shareholders bear less risk per dollar invested, the rate of return they require is lower”

“Therefore, taking the costs of equity as fixed and independent of the mix of equity and debt involves a fundamental fallacy”.

Banker’sNew Clothes (p101)

The basic facts they set out are not really contentious; the mix of debt and equity does impact required returns. The authors focus on what happens to common equity but changing leverage impacts both debt and equity. This is very clear in the way that rating agencies consider all of the points nominated by the authors when assigning a debt rating. Reduced equity funding will likely lead to a decline in the senior and subordinated debt ratings and higher costs (plus reduced access to funding in absolute dollar terms) while higher equity will be a positive rating factor.

Banks are not immune to these fundamental laws but it is still useful to understand how the outcomes are shaped by the special features of a bank balance sheet. My views here incorporate two of the claims they “debunk” in their paper; specifically

Flawed Claim #4: The key insights from corporate finance about the economics of funding, including those of Modigliani and Miller, are not relevant for banks because banks are different from other companies

Flawed Claim #5: Banks are special because they create money

One of the features that defines a bank is the ability to take deposits. The cost of deposits however tends to be insulated from the effects of leverage. This is a design feature. Bank deposits are a major component of the money supply but need to be insensitive to adverse information about the issuing bank to function as money.

Wanting bank deposits to be information insensitive does not make them so. That is a function of their super senior position in the liability loss hierarchy, supplemented in many, if not most, banking systems by some form of limited deposit insurance (1). I credit a paper by Gary Gorton and George Pennacchi titled “Financial Intermediaries and Liquidity Creation” for crytalising this insight (an earlier post offers a short summary of that paper). Another paper titled “Why Bail-In? And How?” by Joseph Sommer proposes a different rationale for deposits having a super senior position insulated from the risk of insolvency but the implications for the impact of leverage on bank financing costs are much the same.

A large bank also relies on senior unsecured financing. This class of funding is more risky than deposits but still typically investment grade. This again is a design feature. Large banks target an investment grade rating in order to deliver, not only competitive financing costs, but equally (and perhaps more importantly) access to a larger pool of potential funding over a wider range of tenors. The investment grade rating depends of course on there being sufficient loss absorbing capital underwriting that outcome. There is no escaping this law of corporate finance. 

The debt rating of large banks is of course also tied up with the issue of banks being treated as Too Big To Fail (TBTF). That is a distortion in the market that needs to be addressed and the answer broadly is more capital though the rating agencies are reasonably agnostic on the form this capital should take in so far as the senior debt rating is concerned. Subject to having enough common equity anchoring the capital structure, more Tier 2 subordinated debt (or Tier 3 bail-in) will work just as well as more common equity for the purposes of reducing the value of implied government support currently embedded in the long term senior debt rating.

Admati and Hellwig are right – there is no free lunch in corporate finance

At this stage, all of this risk has to go somewhere. On that point I completely agree with Admati and Hellwig. There is no free lunch, the rating/risk of the senior tranches of financing depend on having enough of the right kinds of loss absorbing capital standing before them in the loss hierarchy. Where I part company is on the questions of how much capital is enough and what form it should take.

How much capital is (more than) enough?

Admati and Hellwig’s argument for more bank capital has two legs. Firstly, they note that banks are typically much more leveraged than industrial companies and question how can this be given the fundamental law of capital irrelevancy defined by Modigliani and Miller. Secondly, they argue that risk based capital requirements are fundamentally flawed and systematically under estimate how much capital is required.

Why are banks different?

Admati and Hellwig note that banks have less capital than industrial companies and conclude that this must be a result of the market relying on the assumption that banks will be bailed out. The existence of a government support uplift in the senior debt ratings of large banks is I think beyond debate. There is also broad support (even amongst many bankers) that this is not sound public policy and should ideally be unwound.

It is not obvious however that this wholly explains the difference in observed leverage. Rating agency models are relatively transparent in this regard (S&P in particular) and the additional capital required to achieve a rating uplift equivalent to the existing government support factor would still see banks more leveraged than the typical industrial company. Bank balance sheets do seem to be different from those of industrial companies.

Flawed risk models

The other leg to their argument is that risk based capital fundamentally under estimates capital requirements. I am broadly sympathetic to the sceptical view on how to use the outputs of risk models and have been for some time. An article I wrote in 2008, for example, challenged the convention of using a probability of default associated with the target debt rating to precisely calibrate the amount of capital a bank required.

The same basic concept of highly precise, high confidence level capital requirements is embedded in the Internal Ratings Based formula and was part of the reason the model results were misinterpreted and misused. Too many people assigned a degree of precision to the models that was not warranted. That does not mean however that risk models are totally useless.

Professors Admati and Hellwig use simple examples (e.g. how does the risk of loss increase if a personal borrower increases leverage on a home loan) to argue that banks need to hold more capital. While the basic principle is correct (all other things equal, leverage does increase risk), the authors’ discussion does not draw much (or possibly any?) attention to the way that requiring a borrower to have equity to support their borrowing reduces a bank’s exposure to movements in the value of the loan collateral.

In the examples presented, any decline in the value of the assets being financed flows through directly to the value of equity, with the inference that this would be true of a bank also. In practice, low risk weights assigned by banks to certain (low default – well secured) pools of lending reflect the existence of borrower’s equity that will absorb the first loss before the value of the loan itself is called into question.

A capital requirement for residential mortgages (typically one of the lowest risk weights and also most significant asset classes) that looks way too low when you note that house prices can easily decline by 10 or 20%, starts to make more sense when you recognise that that there is (or should be) a substantial pool of borrower equity taking the brunt of the initial decline in the value of collateral. The diversity of borrowers is also an important factor in reducing the credit risk of the exposures (though not necessarily the systemic risk of an overall meltdown in the economy). Where that is not the case (and hence the renewed focus on credit origination standards and macro prudential policy in general), then low risk weights are not justified.

I recognise that this argument (incorporating the value of the borrower’s equity) does not work for traded assets where the mark to market change in the value of the asset flows directly to the bank’s equity. It does however work for the kinds of assets on bank balance sheets that typically have very low risk weights (i.e. the primary concern of the leverage ratio advocates). It also does not preclude erring on the side of caution when calculating risk weights so long as the model respects the relative riskiness of the various assets impacting the value of equity.

How much also depends on the quality of risk management (and supervision)

The discussion of how much capital a bank requires should also recognise the distinction between how much a well managed bank needs and how much a poorly managed bank needs. In a sense, the authors are proposing that all banks, good and bad, should be made to hold the capital required by bad banks. Their focus on highlighting the risks of banking obscures the fact that prudent banking mitigates the downside and that well managed banks are not necessarily consigned to the extremes of risk the authors present as the norm of banking.

While not expressed in exactly that way, the distinction I am drawing is implicit in Basel III’s Total Loss Absorbing Capital (TLAC) requirements now being put in place. TLAC adds a substantial layer of additional loss absorption on top of already substantially strengthened common equity requirements. The base layer of capital can be thought of as what is required for a well managed, well supervised bank with a sound balance sheet and business model. APRA’s “Unquestionably Strong” benchmark for CET1 is a practical example of what this requirement looks like. The problem of course is that all banks argue they are good banks but the risk remains that they are in fact bad banks and we usually don’t find out the difference until it is too late. The higher TLAC requirement provides for this contingency.

What should count as capital?

I looked at this question in a recent post on the RBNZ’s proposal that virtually all of their TLAC requirement should be comprised of common equity. Admati and Hellwig side with the RBNZ but I believe that a mix of common equity and bail-in capital (along the lines proposed by APRA) is the better solution.

Read my earlier post for the long version, but the essence of my argument is that bail-in capital introduces a better discipline over bank management risk appetite than does holding more common equity. Calibrating common equity requirements to very high standards should always be the foundation of a bank capital structure. Capital buffers in particular should be calibrated to withstand very severe external shocks and to be resilient against some slippage in risk management.

The argument that shareholders’ need to have more “skin in the game” is very valid where the company is undercapitalised. Bail-in capital is not a substitute for getting the basics right. A bank that holds too little common equity, calibrated to an idealised view of both its own capabilities and of the capacity of the external environment to surprise the modellers, will likely find itself suppressing information that does not fit the model. Loss aversion then kicks in and management start taking more risk to win back that which was lost, just as Admati and Hellwig argue.

However, once you have achieved a position that is unquestionably strong, holding more common equity does not necessarily enhance risk management discipline. My experience in banking is that it may in fact be more likely to breed an undesirable sense of complacency or even to create pressure to improve returns. I know that the later is not a a winning strategy in the long run but in the short run the market frequently does not care.

What is the minimum return an equity investor requires?

One of the problems I find with a simplistic application of Modigliani & Miller’s (M&M) capital irrelevancy argument is that it does not seem to consider if there is a minimum threshold return for an equity investment below which the investment is no longer sufficiently attractive to investors who are being asked to take first loss positions in a company; i.e. where is the line between debt and equity where a return is simply not high enough to be attractive to equity investors?

Reframing the question in this way suggests that the debate between the authors and the bankers may be more about whether risk based capital adequacy models (including stress testing) can be trusted than it is about the limitations of M&M in the real world.

Summary

The author’s solution to prudential supervision of banks is a shock and awe approach to capital that seeks to make the risk of insolvency de minimus for good banks and bad. I have done my best to be open to their arguments and indeed do agree with a number of them. My primary concern with the path they advocate is that I do not believe the extra “skin in the game” generates the risk management benefits they claim.

I see more potential in pursuing a capital structure based on

  • a level of common equity that is robustly calibrated to the needs of a well managed (and well supervised) bank
  • incorporating a well designed counter cyclical capital buffer,
  • supplemented with another robust layer of bail-in capital that imposes real costs (and accountability) on the shareholders and management of banks for whom this level of common equity proves insufficent.

The authors argue that the authorities would never use these bail-in powers for fear of further destabilising funding markets. This is a valid area of debate but I believe they conflate the risks of imposing losses on bank depositors with the kinds of risks that professional bond investors have traditionally absorbed over many centuries of banking. The golden era in which the TBTF factor shielded bank bondholders from this risk is coming to the end but this broader investment class of bond holders has dealt with defaults by all kinds of borrowers. I am not sure why banks would be special in this regard if countries can default. The key issue is that the investors enter into the contract with the knowledge that they are at risk and are being paid a risk premium commensurate with the downside (which may not be that large if investors judge the banks to be well managed).

This is a complex topic so please let me know if I have missed something fundamental or have otherwise mis-represented Admati and Hellwig’s thesis. In the interim, I remain mostly unconvinced …

Tony

  1. It is worth noting that NZ has adopted a different path with respect to deposit protection, rejecting both deposit preference and deposit insurance. They also have a unique policy tool (Open Bank Resolution) that allows the RBNZ to impose losses on deposits as part of the resolution process. They are reviewing the case for deposit insurance and I believe should also reconsider deposit preference.

“Between Debt and the Devil: Money, Credit and Fixing Global Finance” by Adair Turner (2015)

This book is worth reading, if only because it challenges a number of preconceptions that bankers may have about the value of what they do. The book also benefits from the fact that author was the head of the UK Financial Services Authority during the GFC and thus had a unique inside perspective from which to observe what was wrong with the system. Since leaving the FSA, Turner has reflected deeply on the relationship between money, credit and the real economy and argues that, notwithstanding the scale of change flowing from Basel III, more fundamental change is required to avoid a repeat of the cycle of financial crises.

Overview of the book’s main arguments and conclusions

Turner’s core argument is that increasing financial intensity, represented by credit growing faster than nominal GDP, is a recipe for recurring bouts of financial instability.

Turner builds his argument by first considering the conventional wisdom guiding much of bank prudential regulation prior to GFC, which he summarises as follows:

  • Increasing financial activity, innovation and “financial deepening” were beneficial forces to be encouraged
  • More compete and liquid markets were believed to ensure more efficient allocation of capital thereby fostering higher productivity
  • Financial innovations made it easier to provide credit to households and companies thereby enabling more rapid economic growth
  • More sophisticated risk measurement and control meanwhile ensured that the increased complexity of the financial system was not achieved at the expense of stability
  • New systems of originating and distributing credit, rather than holding it on bank balance sheets, were believed to disperse risks into the hands of those best placed to price and manage it

Some elements of Turner’s account of why this conventional wisdom was wrong do not add much to previous analysis of the GFC. He notes, for example, the conflation of the concepts of risk and uncertainty that weakened the risk measurement models the system relied on and concludes that risk based capital requirements should be foregone in favour of a very high leverage ratio requirement. However, in contrast to other commentators who attribute much of the blame to the moral failings of bankers, Turner argues that this is a distraction. While problems with the way that bankers are paid need to be addressed, Turner argues that the fundamental problem is that:

  • modern financial systems left to themselves inevitably create debt in excessive quantities,
  • in particular, the system tends to create debt that does not fund new capital investment but rather the purchase of already existing assets, above all real estate.

Turner argues that the expansion of debt funding the purchase or trading of existing assets drives financial booms and busts, while the debt overhang left over by the boom explains why financial recovery from a financial crisis is typically anaemic and protracted. Much of this analysis seems to be similar to ideas developed by Hyman Minsky while the slow pace of recovery in the aftermath of the GFC reflects a theme that Reinhart and Rogoff have observed in their book titled “This time is different” which analyses financial crises over many centuries.

The answer, Turner argues, is to build a less credit intensive growth model. In pursuing this goal, Turner argues that we also need to understand and respond to the implications of three underlying drivers of increasing credit intensity;

  1. the increasing importance of real estate in modern economies,
  2. increasing inequality, and
  3. global current account imbalances.

Turner covers a lot of ground, and I do not necessarily agree with everything in his book, but I do believe his analysis of what is wrong with the system is worth reading.

Let me start with an argument I do not find compelling; i.e. that risk based capital requirements are unreliable because they are based on a fundamental misunderstanding of the difference between risk (which can be measured) and uncertainty (which cannot):

  • Distinguishing between risk and uncertainty is clearly a fundamental part of understanding risk and Turner is not alone in emphasising its importance
  • I believe that means that we should treat risk based capital requirements with a healthy degree of scepticism and a clear sense of their limitations but that does not render them entirely unreliable especially when we are using them to understand relative differences in risk and to calibrate capital buffers
  • The obvious problem with non-risk based capital requirements is that they create incentives for banks to take higher risk that may eventually offset the supposed increase in soundness attached to the higher capital
  • It may be that Turner discounts this concern because he envisages a lower credit growth/intensity economy delivering less overall systemic risk or because he envisages a more active role for the public sector in what kinds of assets banks lend against; i.e. his support for higher capital may stem mostly from the fact that this reduces the capacity of private banks to generate credit growth

While advocating much higher capital, Turner does seem to part company with M&M purists by expressing doubt that equity investors will be willing to accept deleveraged returns. His reasoning is that returns to equity investments need a certain threshold return to be “equity like” while massively deleveraged ROE still contains downside risks that are unacceptable to debt investors.

Turning to the arguments which I think raise very valid concerns and deserve serious attention.

Notwithstanding my skepticism regarding a leverage ratio as the solution, the arguments he makes about the dangers of excessive credit growth resonate very strongly with what I learned during my banking career. Turner is particularly focussed on the downsides of applying excessive debt to the financing of existing assets, real estate in particular. The argument seems to be similar to (if not based on) the work of Hyman Minsky.

Turner’s description of the amount of money that banks can create as being “infinitely elastic” seems an overstatement to me (especially in the Australian context with the Net Stable Funding Ratio (NSFR) weighing on the capacity to grow the balance sheet) but the general point he is making about the way that credit fuelled demand for a relatively inelastic supply of desirable residential property tends to result in inflated property values with no real social value rings true.

What banks can do about this remains an open question given that resolving the problem with inelastic supply of property is outside their direct control but it is obviously important to understand the dynamics of the market underpinning their largest asset class and it may help them engage more constructively with public policy debates that seek to address the problem.

Turner’s analysis of the downsides of easy monetary policy (the standard response to economic instability) also rings true. He identifies the fact that lower interest rates tend to result in inflated asset values (residential property in particular given its perceived value as a safe asset) which do not address the fundamental problem of over-indebtedness and may serve to increase economic inequality. His discussion of the impact of monetary policy and easy credit on economic inequality is also interesting. The banks providing the credit in the easy money environment may not necessarily be taking undue risk and prudential supervisors have tools to ensure sound lending standards are maintained if they do believe there is a problem with asset quality. What may happen however is that the wealthier segments of society benefit the most under easy money because they have the surplus cash flow to buy property at inflated values while first homebuyers become squeezed out of the market. Again their capacity to address the problem may be limited but Turner’s analysis prompted me to reflect on what increasing economic inequality might mean for bank business models.

In addition to much higher bank capital requirements, Turner’s specific recommendations for moving towards a less credit intensive economy include:

  • Government policies related to urban development and the taxation of real estate
  • Changing tax regimes to reduce the current bias in favour of debt over equity financing (note that Australia is one of the few countries with a dividend imputation system that does reduce the bias to debt over equity)
  • Broader macro prudential powers for central banks, including the power to impose much larger countercyclical capital requirements
  • Tough constraints on the ability of the shadow banking system to create credit and money equivalents
  • Using public policy to produce different allocations of capital than would result from purely market based decisions; in particular, deliberately leaning against the market signal based bias towards real estate and instead favouring other “potentially more socially valuable forms of credit allocation”
  • Recognising that the traditional easy monetary policy response to an economic downturn (or ultra-easy in the case of a financial crisis such as the GFC) is better than doing nothing but comes at a cost of reigniting the growth in private credit that generated the initial problem, creating incentives for risky financial engineering and exacerbating economic inequality via inflating asset prices.

For those who want to dig deeper, I have gone into a bit more detail here on what Turner has to say about the following topics:

  • The way in which inefficient and irrational markets leave the financial system prone to booms and busts
  • The dangers of debt contracts sets out how certain features of these contracts increase the risk of instability and hamper the recovery
  • Too much of the wrong sort of debt describes features of the real estate market that make it different from other asset classes
  • Liberalisation, innovation and the credit cycle on steroids recaps on the philosophy that drove the deregulation of financial markets and what Turner believes to be the fundamental flaws with that approach. In particular his conclusion that the amount of credit created and its allocation is “… too important to be left to bankers…”
  • Private credit and money creation offers an outline of how bank deposits evolved to play an increasing role (the key point being that it was a process of evolution rather than overt public policy design choices)
  • Credit financed speculation discusses the ways in which credit in modern economies tends to be used to finance the purchase of existing assets, in particular real estate, and the issues that flow from this.
  • Inequality, credit and more inequality sets out some ways in which the extension of credit can contribute to increasing economic inequality
  • Capital requirements sets out why Turner believes capital requirements should be significantly increased and why capital requirements (i.e. risk weights) for some asset classes (e.g. real estate) should be be calibrated to reflect the social risk of the activity and not just private risks captured by bank risk models
  • Turner defence against the argument that his proposals are anti-markets and anti-growth.