Your bank isn’t much safer than the ones that failed in Cyprus

Listen to these folks.
Listen to these folks.
Image: AP Photo/Petros Karadjias
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Why are Cyprus’s bank depositors scheduled to take such a big haircut when their banks are wound up?

Not just because so many are Russian, but more simply: Their banks didn’t have enough equity to avoid losses when loans went bad. Cypriot regulators, eager to attract foreign money, let banks skate by with too little equity to absorb losses while paying a huge 5% interest on deposits. When the cookie eventually crumbled, the people lending to the banks—especially depositors—were the ones left without any crumbs.

Stanford University finance professor Anat Admati says we shouldn’t be surprised. Her new book with Martin Hellwig, “The Bankers’ New Clothes,” examines the way bank funding made the 2008 financial crisis worse and keeps the financial system in ill health today. Post-crisis, regulators have been trying to increase the amount of equity funding for banks, and banks have pushed back, saying that this will reduce what they can lend to people and businesses.

But the banks’ argument is misleading, Admati says. If you look at a bank like any other business, it quickly becomes apparent that banks are carrying far more debt than makes sense for their business model. Unless that business model is to get as many subsidies as they can.

Side-note: Equity is not capital reserves

The terms “equity” and “capital” are often used interchangeably, but they’re distinct. Banks don’t “hold” or “carry” equity, and the amount of equity that they have is not related to the capital reserves—i.e., the cash regulators ask them to keep on hand for liquidity purposes.

Banks, like any businesses, make investments. Ideally, a bank’s investments are loans. It can fund those investments with equity—cash from investors or earnings—or with debt, by borrowing money. (This debt includes bank deposits, which are really just money borrowed from bank-account holders.) The ratio of equity to debt doesn’t affect how much money the bank has available to make loans. But if those loans go bad, banks with significant equity cushions can absorb those losses—their stock just becomes worth less.

However, you can’t write down debt, outside of bankruptcy. If a Cypriot bank full of Greek debt (or a US bank full of mortgage debt) sees those assets become worthless, it can apologize to stockholders for their losses; but creditors must be paid, and that’s where the trouble starts.

Economist John Cochrane offers a simple example:

In order to make $100 of loans, a typical bank borrows $97—from depositors, from money-market funds, from other banks, or from bondholders—and sells $3 of stock, its “capital.” So if only 4% of the bank’s loans fail, the shareholders are wiped out, and the bank cannot pay its debts. Worse, if there is a rumor that some loans are in trouble, creditors may “run,” each trying to get his money out first, and force a needless bankruptcy. Think of Jimmy Stewart in “It’s a Wonderful Life.”

Banks used to be on the hook for everyone’s losses

Banking has always been a debt-heavy business, predicated on customer’s deposits. In the 19th century—at a time when bankers were personally liable for their debts, including to depositors—banks were financed with more than 20% equity. By contrast, the average non-financial company today uses about 70% equity in its funding mix. Today’s banks, under the new Basel III accord devised to make the financial system safer, will triple their equity from current levels by 2019—to a mere 7%. (Update: That rule is based on the ratio of equity to risk-weighted assets; if you compare equity to all assets, the Basel requirement is closer to 3%.)

Bank equity has declined so much in the past century because bank owners were granted limited liability for their debts. However, financial institutions have also been given a slew of subsidies, for good reasons and bad. These include deposit insurance, tax-deductible interest, and the expectation that the government will not allow large banks to fail.

These all have the effect of making debt cheaper for the banks. And so the growing share of debt in the banks’ funding mix has served only to magnify the effects of these subsidies. With high leverage ratios and minimal equity, both the risks and the profits can be huge. And if those risks end up creating a problem, well, the government will make sure the creditors are whole, and that tiny equity stake can always be replaced. All of which makes banks less prudent than they used to be.

Equity should not be more expensive than debt

Admati says the banks would be much safer with a 20% to 30% equity share. As we’ve said, the ratio of equity to debt doesn’t affect how much money a bank can lend. But banks offer other reasons to resist raising more equity.

First, they fret that a higher equity share will increase what they call “the cost of funds.” They say attracting new equity will be expensive compared to borrowing, so they’ll raise less money and make fewer loans, and the public will suffer.

There’s only one clear reason, however, why equity should cost more to raise than debt. That’s the aforementioned subsidies. These make debt cheaper than it should be for companies that have already borrowed a huge amount of money. Bank managers are reluctant to give up that benefit. (Some independent analysts also say that if equity requirements go up, the costs to consumers could rise temporarily as markets adjust.) Admati’s position, however, is that as long the subsidies exist, raising more equity and less debt won’t actually hurt the public, since it’s the largely public that pays for the subsidies.

Bankers also often worry that to raise new equity, they’d have to promise unreasonably high returns to new investors, because of how risky their stock is. But that’s a circular argument: The reason their stock is risky is because they have so little equity. Admati notes that simply issuing new shares would help reduce the risk. A related problem is “debt overhang”—the fear among equity investors that any money put into a bank will simply go to protect the claims of existing creditors when something goes wrong.

The cheapest way to avoid these problems and quickly build up equity and reduce risk is for banks to keep more of their earnings instead of paying them out as dividends. Since raising equity is hypothetically part of America’s strategy for fixing the financial system, Admati is incensed that regulators have repeatedly let the largest banks pay out dividends. For instance, dividends paid in 2007-8, just before the financial crisis, amounted to half the value of the TARP bailouts.

“Allowing the banks to pay dividends is completely and entirely catering to the banks ahead of the public,” she says. “The banks would be stronger and have more ability to lend if they retained their profits. They have to transition and the easiest way to transition is to keep their profits. When they pay it out, they go and borrow instead. They don’t tend to shrink when they make the payouts, they just maintain their high indebtedness.”

Zombie banks can’t lend an economy out of recession

A further reason banks don’t lend is that they still have unrecognized losses clogging up bank balance sheets—what Admati calls “a zombie bank lending to zombie borrowers.” That’s one reason that credit has been hard for businesses to find in America and Europe, slowing the economic recovery.

“It’s actually the distress of the highly indebted banks that already distorts their decisions, including their lending decisions,” Admati says. “I want their lending decisions to be the healthiest lending decisions, not too much and not too little; they tend to have either credit booms or credit crunches.”

The largest banks are still far weaker than many in the public imagine or regulators would admit. That’s especially true in Europe, where weak sovereign debt is all over bank balance sheets. Regulators say that their “stress tests” show the financial sector’s resilience; but Admati thinks the market would pass a harsher judgment, especially with bank balance sheets hiding so many surprises. Even Cyprus’ banks passed stress tests administered by an EU regulator in 2010.

“Here is a sort of ‘stress test’ I would like to run: Can the banks raise new equity? Let them go to the market and see whether investors will give them money in exchange for new shares, not at a price that the banks like, but any price,” Admati says.

She expects many banks would have a hard time selling shares. And that should be warning sign enough to regulators.

“A bank that cannot raise equity at any price may not be viable, and in this case it should be wound down,” she says. “Maintaining unhealthy banks is very unhelpful to the economy. You need to face up to the weakness of the banks.”

Would you buy common stock in a major bank today?