Explaining the fuss over equity capital requirements

Those who have been paying even peripheral attention to the debates over financial reform since the bailouts have doubtless heard about “capital requirements” and “equity capital” without necessarily knowing what those terms mean. In general, this ignorance is by design. The megabankers and their friends have deliberately confused the conversation by using incoherent phrases like “hold capital.” Their goal is to create the perception that a tradeoff exists between a bank’s resilience and its ability to make loans. There is none. So why do they press the point? It’s all about the bonuses: banks that are more resilient would not be able to pay managers and shareholders nearly as well as the banks we have now.

It might help to remember how banking used to work. Until relatively recently, banks held gold deposits in vaults and issued pieces of paper against those deposits. Sometimes the paper was the bank’s debt to its depositors and sometimes it was a bank loan to its borrowers. The bank always faced a tradeoff between putting more paper in circulation, which boosted profits, and suppressing the ratio of paper to gold to convince depositors that their savings were safe.

Banking does not work like this anymore. Banks now fund themselves by taking money (capital) from one group of people in exchange for financial assets (liabilities). Banks then lend this capital out to other people at interest, which creates new financial assets. Pieces of paper are exchanged for others. Strictly speaking, there is no limit to this process—unlike banks that operate under a gold standard.

The liabilities and the assets have to equal, which is why it is called a balance sheet. For illustrative purposes, this is a simplified sample balance sheet for a global megabank:

Can you spot the value-creation?

Either way, you can see that banks fund themselves by creating three basic kinds of liabilities: short-term debt (deposits, interbank loans, and wholesale borrowing), long-term debt (CDs and bonds), and equity (shares). Debt is a promise to pay a fixed amount of cash over a fixed period of time. Equity is a right to claim a share of the profits. Failure to pay interest on debt means bankruptcy, which is messy. Remember AIG and Lehman Brothers? On the other hand, plenty of companies fail to pay dividends all the time. Equity is flexible. Debt is not.

The debate over equity capital requirements is solely about the composition of the right-hand column. It has nothing to do with the size of the banks (they can always issue more equity if they want to) or the nature of their assets. As I have said before, banks do not need to be funded by deposits. In fact, there is no reason why a bank could not be funded entirely by equity. Any mutual fund that invests exclusively in debt instruments is functionally a bank that is 100% equity financed. In the United States, the vast majority of credit is created and allocated outside the commercial banking system. Why then, do the megabankers make such a fuss over equity capital requirements?

Banks, like all public companies, are run by shareholders. Shareholders tell bank managers to maximize return on equity (ROE). But traditional banking is dull and barely profitable. Big banks are lucky to earn more than 1% on their assets after costs, yet they regularly target ROE of more than 20%. The only way to pull this off is by funding assets almost exclusively through debt. This is why the illustrative balance sheet above shows a bank funding only about 7.5% of its assets with equity. Most real-world banks (especially outside the U.S.) are even more averse to equity financing.

This approach is very dangerous. In theory, the victims are the bank’s creditors, particularly bondholders. In principle, they ought to charge risky banks a sizable premium when lending them money. In practice, bondholders do not do so because they know that governments will (almost) always commit taxpayer resources to protect the value of their investments. As a result, creditors fail to exercise discipline over bank management. This encourages banks to purchase the riskiest assets on the thinnest equity base.

Normal firms do not fund themselves this way. Startups go to venture capitalists, which provide cash in exchange for equity stakes. Technology and pharmaceutical companies are notoriously afraid of debt. Yet these firms are the ones most likely to make long-term investments in risky projects that have a chance at improving the human condition. For better or worse (cf. the dotcom bubble) there is no tradeoff whatsoever between equity financing and aggressive investment.

So now you know what the debate is really about. As long as the megabanks banks benefit from the government safety net, which includes access to central bank liquidity, deposit insurance, and the belief that they are simply “too big to fail,” their socially destructive behavior needs to be constrained to prevent them from becoming burdens on taxpayers. Nobody likes a welfare queen. This is why every intelligent, informed, fair-minded person who does not have a vested interest agrees that banks ought to use less debt to fund themseleves and issue more equity—even if this lowers ROE. Now there is an idea that Occupy Wall Street ought to get behind…

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About Matthew C. Klein
I write about the economy and financial markets for Bloomberg View. Before that I wrote for The Economist on a fellowship provided by the Marjorie Deane Financial Journalism Foundation. I have worked at the world's largest hedge fund and read every FOMC transcript since May, 1987.

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