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Plugging the Leaks

MUNICH – With pain and misgiving, the United States Congress bailed out Wall Street in order to prevent a meltdown of America’s financial system. But the $700 billion to be used may flow into a leaky bucket, and so may the billions provided by governments throughout the world. 

The US financial institutions that went bankrupt in 2008 – or that would have gone bankrupt without government help – were in trouble because they lacked equity capital. They did not lack that capital because they never had it, but because they paid out too much of their abundant earnings in previous years to shareholders, leveraging their operations excessively with debt capital. If no measures are taken to increase the minimum equity requirements for banks and other financial institutions, financial crises like the current one could recur.

Anglo-Saxon financial institutions are known for their high dividend-payout ratios. From a European perspective, the hunger for dividends and the emphasis on short-term performance goals that characterize these institutions is both amazing and frightening. Investment banks, in particular, are known for their minimalist equity approach. While normal banks need an equity-asset ratio of at least 7%, investment banks typically operated on a ratio of only 4%.

The lack of equity resulted largely from the concept of “limited liability,” which provided an incentive for excessive leveraging. Earnings left inside a financial institution can easily be lost in turbulent times. Only earnings taken out in time can be secured.