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«The free market really fails in Banking»

Anat Admati urges regulators to give citizens a stable financial system. They must ask for more equity to be held by banks. And Banks should be brought into an existence which is more similar to other corporations. We should not subsidize leverage, which lets banks take too much risk, and then pay the bill if things go wrong. Coco-Bonds are no substitute for equity, says Admati.

Professor Admati, banks equity in relation to their balance sheet has declined throughout the last 150 years, but never as dramatically as since the 1980s. Banks have grown even too big to let them fail, because a default would harm taxpayers more than a bailout of the banks would cost them. And during the last Crisis, global Megabanks have grown even bigger in terms of their balance sheet. How did we get into this situation, where banks can blackmail the taxpayer when they are on the brink of bankruptcy?
When big banks get into trouble, they leave us with grim alternatives: either we bail them out with our money, or their default brings a disaster to the rest oft the economy. That is why it is so important to focus on preventing banks from getting to the brink of default..

But we got that far and we found ourselves in that trap. Why did we build a regulation and a system that allowed this to happen and leaves us with such alternatives?
That’s a very good question. I believe, banks got away with narratives of the sort «what’s good for them is good for everybody». In the issue of risk an indebtedness, that’s just false. They tell themselves and other people, that the way they are is the way they should be.

And the regulators, politicians and even the general public has bought into that story, for years?
There are two types of mindsets that allow for this to happen: One is the notion that free markets work. This was the Alan Greenspan view: we don’t need to regulate, because markets work. Such a view leads to a bias against regulation so that the market forces play freely. But what is not recognized here is that the forces here are destructive. The other – and this part comes often from the more progressive political side – is a temptation and a love of credit. So, for example, the view, that if we want an institution to make more loans, we subsidize it, and that has meant subsidizing its borrowing with the hope that therefore it will make the loans we want it to make.  And make them cheap. That is part of what happened in the market for housing loans in the US: people think, that if they guarantee banks and there liabilities, they will end up doing, what would be in the general interest. The problem with this view is that credit booms usually are followed by credit busts, so it is a very short sighted view, which politicians sometimes have. So it is a combination of a bias against regulation and the idea, that if we subsidize banks in the easiest ways, and that is by giving them an implicit guarantee, they will do what we want them to do.

Talking about free market in the banking sector: the hurdles for competitors to enter the market are huge.
That’s another problem with allowing for too dominant banks: too much concentration in the sector and an inability to compete with them. These banks can win in every competition because they have a funding advantage over everybody due to the too big to fail guarantees. That distorts costs and prices, the free market really fails in Banking. That is what we need to correct with good and effective regulation. It doesn’t mean to intervene too much; it just means to correct for the failure of the market and to protect the public.

Beside these guarantees out of Too Big To Fail there is this yet another subsidy: the tax deduction of interest payments and that is the subsidization of debt over equity. Where does this come from?
As far as I can tell, it is a historical coincidence.

A coincidence that has determined our lives for so long. We never managed to change it and are even accepting it as a quasi-natural law.
Yes, there is no economic rationale, none. You can see it in the case of Coco, the Contingent Convertible Bonds, that Banks have been allowed to issue and that counts as loss absorbing capital instead of equity. When the equity ratio of a bank’s capital structure falls below a certain threshold, called trigger, the bond gets converted into equity. The tax must define somehow what security is considered debt and when the tax deductibility of interest is possible. We must remember that the tax law hasn’t been written by God, but by human beings. And therefore human beings could correct it, and they should. In the US, since the holders of Cocosare not entitled to wipe out the shareholders and take over, Cocos do not qualify as debt for the purpose of deducting interest. Therefore in the US they don’t benefit from a tax advantage over equity.

Unlike in the US, in Switzerland and other European Countries Coco qualifies as debt, with all the tax advantages. Why introduce a new type of debt to recapitalize the banks, although it is widely recognized that the root of the crisis was too much debt and not enough equity.
I think the reasons are all bad ones. It’s just to give a tax subsidy to the banks, from which they benefit from already to a much higher extent than other companies. And by the way: the tax issue could be settled separately. Tax is just a cash amount. The amount can be determined without giving incentive to use dangerous amounts of debt. Why should they be encouraged to do things that are harmful and that we have to regulate against? It’s perverse. We usually don’t subsidizesmoking, and then ban it, do we? It makes no sense. Especially in the case of banks, you don’t want to encourage them to take more debt. I would subsidize equity before I would subsidize debt. And bank managers say, they want to issue Coco because it doesn’t interfere with their return on equity, the RoE, a totally flawed reasoning. So, for them it seems to be about this hate of the E, which means equity.

That’s because as long their funding it is not counted as equity but as debt, the debt magnifies their return on equity.
Yes, because they buy assets with the debt, without increasing their equity. And this means it increases their RoE on the upside (when they surpass their borrowing cost), which they love so much and by which they are measured and get paid. So, as long it’s not equity, they prefer it. But for the wrong reasons. If Coco does absorb losses, it’s going to do just the same as equity, but until then, the banker can continue to stock 20% RoE or something unreal like that.

There are supporters of Coco among academics, too.
Some academics considered Coco a clever idea, but there was never given any good reason, why this kind of security should start life as debt and how reliable it would be in converting it into equity at the right time, particularly in a crisis situation. There seems to be a sort of magical thinking involved about how it would work.

So, were regulators ready to invent a very complicated funding instrument just to let banks avoid equity?
I am not sure why they allowed Cocos, but Cocos have no advantage over equity in absorbing losses  and no cost advantage – except possibly for taxes – if they work as planned. One of the amazing things to ask about Cocos – and this is really the test question – is this: why don’t we see Cocos issued by other companies? If Cocos cleverly get the tax advantage of debt and they will prevent bankruptcy because they will just convert in time, why does not every corporation use Cocos instead of much of its equity? Why then don’t we see Cocos in the real world of other companies?

Why don’t we?
Because they are not compelling securities  from the perspective of the economics of funding. A normal convertible bond has the option for the creditor to convert it into equity. And since debt can create the incentive for management or shareholders to take too much risk, a convertible bond corrects this by giving the option to the lender to participate on the upside if risk was taken. This mitigates the risk shifting problem. Cocos don’t do that.

But if investors are buying Cocos, can they be so bad?
You can sell any security if the price is right. They pay a lot of interest, everybody is booking a nice spread so there is no problem there. Maybe the banks are overpaying. People usually buy fixed income (debt securities) exactly for the downturns. In that context Cocos are a strange sort of security: They have the «upside» of a debt (which is to be paid what is promised) and the downside of an equity, when converted in bad times, without wiping out existing shareholders. You can find a price to compensate for the risk, which someone must bear. It is possible to sell any if the price is set for investors to buy it.

In the beginning the pricing of Cocos was uncharted waters for the industry.
And they still may not quite know how to price it. It’s a complicated security. From the perspective of regulation, there is no need for it. It’s a completely unnecessary thing. If we need more loss absorption we should go for more equity, because it does the trick, without all the complications of Cocos. There are papers that show an enormous instability around the trigger where the Coco converts into equity if it depends on the market value of the equity. If the trigger depends on accounting values, they can be manipulated. And then after Cocos convert into equity, suddenly the tax deductibility disappears. Why are we here? Why are we complicating our lives?

Another story the banks like to tell: if we have to more equity, we can make fewer loans.
That’s nonsense. Funding with equity does not restrict investments, in fact, companies that have less debt generally make better investment decisions.

Yes, but it is a very stable nonsense and it is well anchored one, and it’s out there. Why have scholars and the media failed to exorcise it from everyday economic thinking?
Paul Volcker said in this regard to a US senator in 2010: anytime you propose to do something about banks, they will always come up saying: credit will suffer and growth will suffer. And he added: It’s all bullshit. I respond to it by noting: Look at the big banks, lending is a small part of what they do. J.P. Morgan Chase does not even lend all its deposits. So how are they prevented from lending if they need to have more equity? They have plenty of money to lend. They just choose to do other things. The notion that asking them to use more equity funding prevents them from lending is ridiculous. Paying out dividends immediately shows it to you: They say that they are prevented from lending and meanwhile they are paying out money that they could lend.

Why do banks prefer to do other things than lending? Why has lending, which should bring together a nations savings with its productive ideas, become such a small part of a bank’s balance sheet?
Because  often the banks  prefer other investments. Lending might not bring them 30% RoE, it’s not as much fun as other investments. And also, debt overhang makes «boring» but worthy lending unattractive, and so do the risk weights used in regulation.

And there is yet another story: that if the banks fund themselves through equity, it is more expensive then through debt.
That’s only true because debt is subsidized by implicit guarantees and tax deductibility. And of course their funding costs will go up when you strip them of these. But we are paying the subsidies which then on top of that give the banks the possibility to make dangerous things like destabilizing the financial system or distort lending. And when the damage is done, we will have to pay for that too.  And also, the issuance of more equity will make the bank safer and the risk premium of both equity and debt investors will decline.

What is wrong in Basel III and what could be a black box for banking, a device like it’s used in aviation to track what did really happen and who is at fault. What is the problem and what can be done?
The problem lies in the political system. Each nation should think about its own citizens and how to give them a stable system. And a stable system means that the banks are brought into an existence which is more similar to other corporations, especially in their funding. And if you want to subsidize anything or anybody you find different ways to deliver them then to go through the borrowing of the banks. There are a lot of distortions in subsidies but you have to focus on what you want to achieve. The decision is always and all the time ours, collectively. Sometimes it’s more law, sometimes more regulation.  But it’s possible to have a better system, in every country and globally. In the US there is plenty of authority to the regulators, but sometimes the politicians push them in not doing more and sometimes they themselves choose not to do more. But they have plenty of opportunity to correct this.