Thursday, November 27, 2014

Love the Bank, Hate the Banker

NEW DELHI – Public discourse is rarely nuanced. The public’s attention span is short, and subtleties tend to confuse. Better to take a clear, albeit incorrect, position, for at least the message gets through. The sharper and shriller it is, the more likely it is to capture the public’s attention, be repeated, and frame the terms of debate.

Consider, for example, the debate about bank regulation. Bankers are widely reviled today. But banking is also mystifying. So any critic who has the intellectual heft to clear away the smokescreen that bankers have laid around their business, and can portray bankers as both incompetent and malevolent, finds a ready audience. The critic’s message – that banks need to be cut down to size – resonates widely.

Bankers can, of course, ignore their critics and the public, and use their money to lobby in the right quarters to maintain their privileges. But, every once in a while, a banker, tired of being portrayed as a rogue, lashes out. He (it is usually a man) warns the public that even the most moderate regulations placed on banks will bring about the end of civilization as we know it. And so the shrillness continues, with the public no wiser for it.

A more specific example drives home the point. A significant number of banks operated at very high levels of leverage prior to the recent crisis, with debt/equity ratios of 30-1 (or more) in some cases, and with much of the debt very short-term. One might reasonably conclude that banks operated with too little equity capital, and too little margin of safety, and that a reasonable regulatory response would be to require that banks be better capitalized.

But this is where the consensus breaks down. The critics want banks to operate with far less leverage, especially regarding short-term borrowing; indeed, some want all-equity banks, so that the system becomes safe. The bankers retort that they must pay a higher return on any additional equity that they issue, so that more equity would increase their cost of capital, forcing them to raise interest rates on the loans they make, which would reduce economic activity.

Neither side is quite right in their public arguments. The bankers do not seem to have internalized a fundamental axiom of modern finance: risk emanates from the assets that a bank holds. According to the Modigliani-Miller theorem, the mix of debt and equity that it uses to finance its assets does not alter its average cost of financing. Use more “cheap” debt, and equity becomes riskier and costlier, keeping overall financing costs the same. Use more equity, and equity becomes less leveraged and less risky, which causes investors to demand lower returns to hold it, and again the overall financing cost remains the same. Put differently, given a set of cash flows from a bank’s assets, the bank’s value is not affected by how those cash flows are distributed among investors, so more leverage does not reduce the bank’s cost of funding.

If their public argument is incorrect (and they must know it), why do bankers prefer short-term borrowing to long-term equity finance? The critics would say that it is because of the tax preference accorded to debt, or because banks are too big to fail.

But these arguments do not withstand scrutiny. If the tax deductibility of interest made debt attractive, then bankers should be indifferent between long-term debt and short-term debt. Yet they seem to prefer the latter.

Similarly, too-big-to-fail banks would not care about the failure risk associated with debt financing. But, again, it is unclear why they should prefer short-term debt. After all, if bankers were trying to benefit, would they not issue long-term debt, for which the default risk, and the gain from the implicit government guarantee, is high? Furthermore, why do small banks, which have no implicit backing from the government, also have so much leverage?

The critics’ arguments about the benefits of equity are equally unsatisfying. Of course, given a set of bank assets, more equity would reduce the risk of failure. But failure is not always a bad thing; a banker operating an all-equity bank, with no need ever to repay investors, would be likelier to take unwarranted risk. The need to repay or roll over debt imposes discipline, giving the banker a stronger incentive to manage risk carefully.

For example, when Washington Mutual collapsed in 2008, following an uncontrolled lending spree (it was the largest bank failure in American history), it was not because equity holders decided to close it down, but because depositors did not trust it anymore. How much more value would Washington Mutual’s management have destroyed if the bank had been all-equity financed?

In sum, there are tradeoffs. Too much short-term debt makes banks more prone to failure, while too much equity places little restraint on bankers’ capacity to destroy value. The truth lies somewhere between the positions of today’s strident critics and indignant bankers, which may be why the moderately leveraged bank has been a feature of Western economies for a thousand years. Our distaste for the banker must not be allowed to destroy the bank.

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    1. CommentedKP Vinod

      The article is a targeted technical solution to a problem that has more nuances than a choice of management of risk in the form of equity or debt. I am reminded of a cartoon by R K Laxman that paraphrased meant "why rob a bank ... take a loan".

      My problem though is with the fashionable title.

      Bankers like bureaucratss operate on positional power, and the inflation of bankers to experts (likewise the conflation of generic management skills as roving industry expertise) - has resulted in an unequal but perverse relationship between the infrastructure gatekeepers (in this case money providers) and the industrialist / entrepreneuer.

      Nothing in this crisis seems to suggest anything other than a conscious attempt to game the system - bankers / industrialists / politicians etc., - while that may tar everyone with a broad brush, it may be closer to the truth. From my understanding, the ones that walked away from this crisis with gains or hardly any downside are those who actively gamed the system.

      The assessment of reasonable risk being an esoteric exercise limited to a cozy club of bankers and businesses - Any attempt to explode the myths behind risk / derisking / assessment of the current darling "innovation" - suffers from a grander delusion that the government (and the economy) and all of us bystanders are expected to be in thrall of these growth / market makers.

      The descent of politics to either sops or FDI bytes and politicians as some kind of market facilitators (middlemen?) completes and accentuates the collusive mix.

      In the current environment a nuanced approach such as this article suggests hardly faces up to the covert tactics / hidden assumptions - particularly in the Indian context.

      So, while the title "Love the bank, hate the bankers" has all the connotative overload of balance and fine nuance - in an economy where gaming the system is rampant it is ineffectual as a suggestion or direction.

      Maybe an analogy will help - try, "love the police, hate the policemen", "love the hospital, hate the doctor" - maybe this is about separating structure / form/ function.

      But in some practical sense of our simple model of our world - this suggestion messes with our understanding that "what it does is what it is".

      In all earnestness, I am trying to love our bureaucracy (politics), while I (try not to) hate our bureaucrats (politicians).


    2. Commentedcaptainjohann Samuhanand

      The top Private sector banks in India, the ICCI bank, Axis Bank, and HDFC bank were caught a sting operation where their top executives teach their clients how to do "Hawala" trade ans other illegal activities with their ill gotten money ofcourse.. None of the Public sector banks are involved in this but then they are milked by the Big fat cats like Vijay malllyya who owns a cricket team, F1 team but does not pay his employees and also does not honour the bank loan he took and that is how the Indian system works .But write off farm loans all financial media cry foul on wink from world bank or MNC capital as theycan only tolerate write of Big fat cats money but no poor farmers who does not have farm insurance

    3. CommentedProcyon Mukherjee

      The crucial point is how the subsidies that the large banks receive in form of low cost of capital (which the smaller ones would find impossible to muster) and together with the implicit and explicit guarantees (deposit insurance) make high risk trading with a high return sustainable up to a point, while when the things do not go well have the public funding return for recapitalizing or even complete bail-out. Are we sure that the Dodd-Frank Act is being followed in letter and spirit and that the high risk trading activities are taken out of the public risk pool?

    4. Commentedsrinivasan gopalan

      The title "love the bank, hate the banker" said it all in that the banks being managed today, whether in the advanced countries or in emerging market economies such as India, are so slovenly managed that a crisis is brewing or broke out as in 2008. The excessive leverage and indiscriminate lending that marked the acme of the banking crisis bears out conclusively that pricing of risks which is the fundamental remit of the banking industry had not been properly adhered to. Banking as an industry or a catalyst for growth of the national economy could be viable if only the people who manage the affairs of the banks do get their act together in pricing risks they take prudently and properly. As Mr Rajan ended up his treatise that the western economies' had a moderately leveraged banking industry for 1000 years, but unfortunately this was not so during the run-up to the 2008 crisis. It is time bankers recognized their folly of poor risk perceptions and accordingly honed their skill in this regard so that this would be beneficial both to the bank and to them over the long haul. G.Srinivasan, Journalist, New Delhi, Inde

    5. CommentedGerry Hofman

      Our distaste for the banker must not be allowed to destroy the bank. But it can impose limits on their earnings, and cap their bonuses. And prosecute when their reckless behaviour hurts thousands. Being a banker must stop to be seen as a one way street to join the ranks of the ultra-rich. A social conscience may be hard to come by, but society needs to get a grip on those at the top of the system.

    6. CommentedJakob Stenfalk

      There is, in fact, a simple explanation for the preference for short-term borrowing, which very nicely dovetails the discussion of the preceding paragraph: The central bank conventionally intervenes only at the extreme short-maturity end of the yield curve.

      The short-maturity end of the yield curve is therefore set by the central bank's interest rate policy, in the service (one must hope) of macroeconomic objectives. Which usually indicate setting this risk-free subsidy to voluntarily idle wealth somewhat below the risk-adjusted return to equity, so as to encourage voluntarily idle wealth to cease being idle.

      If financial markets were efficient this would dictate the remainder of the yield curve, as arbitrage would align it with expected future central bank policy, give or take the market price of interest rate and maturity risk.

      This is the first reason to expect banks to prefer short-term funding: Banks are in the business of assuming interest rate and maturity risk and getting paid for it. Paying someone else to take it off their hands would be to outsource a core part of their business model.

      But of course if financial markets were efficient, systemic financial crises like the present would be impossible. And they aren't, so they aren't.

      The upshot of this is that the long-maturity end of the yield curve is set somewhere between the required return in the equity markets and (the lower rate) where it would be if the markets were efficient, providing yet another incentive for banks to fund short-maturity.

    7. CommentedJakob Stenfalk

      This paragraph seems to omit a crucial underpinning of the Modigliani-Miller result: That the firm under consideration borrows at the same rate as the prospective buyer of its equity.

      In fact, banks are given the privilege of borrowing at preferential rates from the central bank (or the interbank market, but that comes to the same thing in the end - all interbank liquidity ultimately comes from the central bank).

      Keeping in mind that:
      *Liquidity is a public good (and very cheap for the central bank to provide), and
      *Equity is generally not acceptable collateral at the discount window, and financial regulators tend to frown on banks that load the asset side of their balance sheets with equity (since this essentially allows them to square their leverage)

      It is therefore not obvious that there exists any simple, enforceable arbitrage relationship between the cost of funding in the equity markets and the cost of funding in the interbank market or at the discount window.

      (In fact if the Modigliani-Miller result were to hold for banks, that is if the policy rate faithfully recapitulated the risk-free return to equities, there would be no particular point in having banks at all: The purpose of banks is to allow firms and households to leverage the power of the state, through the central bank, to mobilize resources which the equity market, if left to its own devices, would have left idle.)

    8. CommentedCris Perdue

      The article says, "a banker operating an all-equity bank, with no need ever to repay investors, would be likelier to take unwarranted risk." Whose equity do you think this is?

      If the banker's own, then he would be a fool to take unwarranted risks. If it belongs to investors they will expect to be paid back with profit, and will be glad to fire him when they or the stock market sees the risks as unwarranted. If the operations of the bank are sufficiently opaque, the market may not be able to operate as it should, an important but different question.

    9. CommentedKubilay M Öztürk

      ...I guess what is needed is an overall reform in economic plumbing with an intensified focus on how externalities (frictions) could impact reaction of the market economy. Unfortunately, over the course of last 30 years or so, main street perception has been the notion that markets would take care of themselves. Now, it is time to acknowledge that bad politics comes from bad economics.

    10. CommentedKubilay M Öztürk

      Proposition that Modigliani-Miller theorem has been widely missed by the banks (or the bankers as it would be realistically impossible to part them) is unfortunately a tad misplaced. A small change to the underlying assumptions (such as fixed return from assets or frictions in obtaining equity versus debt financing) would be enough to prove that the theorem would not hold in reality. And a closer look to differences in relative frictions for debt or equity funding - rather than layman arguments such as tax benefits - could indeed explain why bankers have overwhelmingly opted for such an unsustainable path. While a middle-path for equity-vs-debt mix in bank balance sheet is a tempting and convincing conclusion