Equity, again

For some, it is the panacea to all problems in banking, others sees it as just one pillar among many, while banks themselves usually complain about it: capital regulation. Should banks carry more equity? Always a prominent topic in financial regulation, it is once again on top of the policy agenda, with the US president ordering a review of Dodd-Frank post-crisis regulation (motivated, i.a., by his impression that „his friends can’t get credit“ anymore), while French presidential contender Macron is demanding extensions in equity capital (buffers) to be set by EU finance ministers, and Deutsche Bank initiating a massive share issuance programme. Add to this the general debate on reforming the Basel accords…what’s the fuss all about when we are talking about equity and debt?

I. Don’t be duped: Capital is not „held“ in a vault

As a starting point, it makes sense to not be distracted by the dichotomy of „owners“ and „creditors“ of and to a bank as generally used to distinguish equity-holders on one hand from debt-claimants on the other.

The difference between equity and debt should simply be seen in the fact that the former comes with an obligation to be payed back at some point (fixed claim). Holders of equity, in contrast, are not promised anything but the mere prospect of receiving what is left after everyone else is paid (residual claim) – which may be a lot. On the flipside, that’s only fair because shareholders are the first to absorb the bank’s losses (residual risk-bearers).

Essentially, capital regulation is about how a bank is supposed to fund its activities (source of funding) and not about how a bank may use these funds (use of funds). If a bank is not able to fulfill the fixed debt obligation, it is insolvent and supposed to be wound down. That, however, is highly problematic, one reason here being that certain claims against banks (demandable debt) are functionally „money“ since they are part of the payment system and used to settle real-life transactions. To prevent harm for the real economy, taxpayers will step in and bail-out the bank. Herein lies the rub: Unlike in normal companies, it is not only the shareholders bearing the residual risk, but also the taxpayers (this justifies taxpayers’ control rights, that is, public regulation). Requiring higher equity ratios therefore equals requiring higher financing from residual claimants, that is, actual shareholders who are not promised back anything.

It should be clear from this that, when we are talking about capital regulation, we are not talking about how banks are allowed to use the capital. Consequently, conjuring the image that banks are required to „hold“ cash sitting in a vault which could not be lent out to real businesses is plain wrong. However, it makes sense from banks’ private perspective to use this metaphor to influence public debate – who doesn’t want real and innovative businesses to get financing?

Proponents of higher capital requirements reply that this is a red herring: if banks incur higher funding costs issuing equity, this is because shareholders do not enjoy the pleasant company of taxpayers in sharing the bank’s residual risk any longer (for more arguments, listen to this terrific podcast with Prof Admati).

II. Complexities of capital regulation

As a practical matter with capital regulation, the devil is in the details – raising equity ratios alone won’t do the job: current rules still put heavy emphasis on different „risk-weights“ and let banks use their own internal models to calculate risk. Both do not adequately capture risks and are prone to being gamed, which is why Basel regulators are currently discussing whether to limiting the extent to which these internal models can be used (by setting up minimum „floors“ of risk).

And, as always, one cannot help but see political influences and industry interests at work here. Given the scope of societal loss at stake in financial crises, capital regulation should best not be left to short-sighted or self-interested politicians or regulators. One, admittedly politically unpopular, method would be to make use of disinterested market based assessments of banks’ capital situation as put forward by Prof Cochrane.

III. Make capital simple again

Demanding higher equity ratios might also serve as an alternative to complex capital regulation and complex bank balance sheets. As Andrew Bailey, head of the UK prudential authority, puts it:

The essence of the argument as I see it is that it is asserted by supporters of, let’s call it the “big equity” school, that we cannot value large banks adequately because they are too complex and opaque, cannot supervise them effectively and cannot resolve them, we must resort to an approach which requires a sizeable shift in the balance of their funding away from value certain deposits contracts towards loss absorbing equity type contracts. This is on the basis that there is then a large buffer to absorb the losses that will flow from inadequate valuation and supervision, and without recourse to resolution. For me, this begs the question of the appeal of a proposition which states to the public: “will you please provide equity funding to something we can’t value or properly oversee”.

Complex capital rules also disproportionally encumber small institutions. That’s why US lawmakers are calling for substituting complex regulation with simpler rule once a certain capital threshold is met (CHOICE Act) or why German Finance Minister Schäuble calls for a “small banking box“.

Admittedly, being a shareholder in a bank is not that attractive an investment in times of unfashionable bank business models, low interest rates and high numbers of non-performing loans congesting banks’ balance sheets. However, let’s keep in mind that equity is not „held in a vault“ and might even serve as an instrument allowing for proper deregulation where necessary.

 

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