Anat Admati’s simple proposal for stopping financial crises: Target debt, not assets

Obviously, the financial crisis of 2008, and the subsequent recession and anemic recovery, was a really big deal. Even if we bounce back to 3% GDP growth rates in this year and the next, the second-order and aggregate effects of the financial crisis will continue to drag on American and global economic growth for literally decades to come. Probably the biggest cost of the recession has been high unemployment among the young, which has prevented members of my generation from accumulating skills, experiences, and savings that they otherwise could have — skills, experiences, and savings that could have done much to contribute to our economic future.

So how can we stop a financial crisis like our last one from happening again? Well, to massively oversimplify, the last financial crisis happened because banks had taken out huge amounts of debt to buy assets whose values were tied to the housing market, and the housing market faltered, causing the value of those assets to decline, which left some financial institutions insolvent, fundamentally unable to meet their obligations to others, and all the panic and uncertainty meant that even fundamentally sound banks lost access to credit they needed to hold them over through the crisis. So how do we stop this from happening again? Well, most of the discussion has centered around regulating banks’ assets. Most people want more regulations and stronger regulators on banks asset purchases–passing regulations to require banks to take on less risk and giving regulators more authority to look at their balance sheets and make them change their asset allocations if they’re being too risky.

But there’s a theoretical problem with this line of thinking: Financial institutions really don’t like going bankrupt (though, notably, the policy of Too Big to Fail can cause a problem of “moral hazard” here). They really do their best to find assets that will increase in value over time. Plus, banks these days — for better or worse — employ a lot of the smartest people in the world — economists, physics and math PhDs, etc. — to model what’s happening in the economy, figure out the probable impacts on their assets, and use that to figure out how to help their bank prosper. And this means that it’s not realistic to expect that the next financial crisis will be averted because a few government regulators getting paid $120,000 a year go up to a few Goldman Sachs economists making $5 million a year, and say, “Hey, look, your assets are going to decline in value, and you’re going to go bankrupt,” and the Goldman Sachs economists will say, “Oh, crap, we hadn’t thought of that.”

If that sounds snarky, let me put it more formally: The value of an asset represents the market’s best assessment of the total discounted future expected returns of that asset. To say that “the value of these assets will decline in the future” is an inherently counter-cultural, quixotic, non-consensus prediction, because the market incorporates its predictions for the future into the current market value of assets. If regulators are smarter than the market and can predict the future better than the market can, then they all should have already made billions and billions of dollars doing their own trading by now. (They generally have not.) In other words, declines in the value of assets are by definition unpredictable — so giving regulators power to stop banks from buying assets that they (the regulators) think are unwise purchases will almost certainly not work. To illustrate this basic theory with actual history: In the mid 2000s through 2007, the Fed assured us over and over again that the housing market was no cause for concern — in late 2007, most economists did not think that the U.S. would enter a recession in 2008 (we were already in one at the time). Regulators will not predict the next financial crisis in advance, because financial crises are by their nature unpredictable and unpredicted.

So what else can we do? Instead of giving more power to regulators, could we give more power to formal, unbiased, conservative regulations about the kinds of assets banks can hold, i.e., requiring that they buy relatively higher amounts of very safe assets, like U.S. Treasuries? This is, in my view, a better line of thinking, but not the ideal primary policy approach. Indeed, one could argue that one contributor to the last financial crisis was, e.g., the requirement that banks hold a certain portion of AAA-rated assets, and the ratings’ agencies stupidly giving Mortgage-Backed Securities AAA ratings. Ironically, the fact that banks could formally meet some of their requirements for AAA assets by buying these MBS actually helped drive up the demand for, hence the price of, MBS, which could have occluded and distorted price signals about their riskiness. In other words, ultimately the “more regulation of asset purchases” idea falls to the same argument as the “stronger regulator power over asset purchases” argument — if we knew which assets were risky in advance, they wouldn’t be so risky. Another objection is that we as a society actually do want banks to do plenty of risky investing, in, e.g., innovative but young companies with uncertain but potentially awesome futures. The tech bubble of the late 90s eventually got overheated, but it’s basically a pretty great thing that American capitalism could hook up a lot of brilliant entrepreneurs in California with the money they needed to implement their crazy ideas to change the world. It’s not clear that we’d be better off as a society if more of that money had gone into pushing yields on U.S. Treasuries even lower.

So what do we do instead? The big idea that’s catching on in the econ blogosphere, and which I’ve been persuaded by, is that we ought to stop focusing on banks’ assets per se, and instead focus on how they finance those assets. One way to think about this is that, as I wrote above, we’ll never see the next big decline in asset values in advance — it will always, by its nature, be unpredictable — but we can increase the chances that the financial system will be robust through such a period. How could we do this? It’s simple: If banks financed more of their assets with equity, and less with debt, they would be able to suffer a greater decrease in the value of their assets without becoming insolvent. So we simply force banks to have more equity relative to their debts: we could do this by simply making them reinvest all their earnings (i.e., not pay out any dividends) until they met the desired ratio. This idea is being advocated most powerfully and vociferously by Professor Anat Admati, as in her new book, The Bankers New Clothes.

Let’s step back to make sure we’re all absolutely clear on the terminology here: If I’m a business, every purchase I make is formally financed by either equity or debt. When I first start my business, I invest $10,000 — that’s equity; when I get a $10,000 loan from a bank, that’s debt. When I spend that money to buy up office space and inventory, then I have $20,000 of assets, financed equally by debt and equity (meaning I have a ‘capital structure’ of 1 to 1). If I make $5,000 right away, then those profits count as new equity immediately, and so I have $15,000 of equity for $10,000 of debt. If I pay those $5,000 out to the owner (myself) as dividends, then those $5,000 are in my personal bank account, and longer on the company’s balance sheet, so the company is back to the 1 to 1 capital structure ($10,000 of debt and $10,000 of equity). If my office catches on fire and now my assets are worth only $10,000, then I now have 0 in equity, because I still owe $10,000 to my creditors. If I invite a partner to come share ownership of the company with me, his/her investment is new equity.

In the run-up to the financial crisis (and still today), banks were famously highly ‘levered’; Lehman Brothers’ assets were financed by some 30 times as much debt as equity. This is sort of like buying a house for $300,000, while making only a $10,000 down payment. What’s so bad about taking out all this debt? The problem is that, the more debt/less equity you have, the greater are your chances of bankruptcy. You legally have to pay off your debts regardless of circumstances (your debt does not decrease because you had a bad year) but your equity just goes with the flow of your assets. If my company has $100,000 in assets, with a capital structure of 1 to 1, and our assets then decline in value to $80,000, then that sucks for me and my fellow owners — our equity just fell from $50,000 to $30,000 — but we can still pay off all our debts and remain a going concern. But if we had financed our $100,000 in assets with a leverage ratio of 9 to 1 ($90,000 in debt and $10,000 in equity), then the same decline in the value of our assets would leave us completely insolvent.

When banks are levered up 30 to 1, just a 3% decline in the value of their assets can leave them insolvent, unable to meet their obligations. When lots of banks are levered up this much, even smaller declines in the value of their assets can put them at risk of insolvency, which can, in turn, force them all to sell off assets in fire-sales, pushing down the value of financial assets even further, or cause them to lose access to credit, leading to a self-fulfilling prophecy, financial contagion, and a credit crisis necessitating bailouts, etc. In other words, each bank’s leverage has negative “externalities” on society as a whole.

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Why do banks take out all of this debt? There’s one fact everyone agrees on: One major contributor is the debt bias in the U.S. tax code. Corporations can deduct the interest they pay on their debt for tax purposes, while they cannot deduct the dividends they pay out to shareholders — indeed, dividends get taxed twice, first as corporate profits and then as income for the owners who get them. This debt bias gives banks a relatively greater incentive to take out more debt. It also means, unfortunately, that if we did undertake Admati’s proposed reform without getting rid of the biased tax incentives against equity, banks would see their costs of funding rise, which could increase the cost of credit throughout the economy. (N.B.: She does want us to get rid of the debt bias as a part of her proposed package of reforms.)

But what if we could get rid of the debt bias? Then could we all agree to increasing banks equity-ratio requirements? This is where the discussion gets tricky and contentious. A lot of bankers are arguing that even if we could get rid of the debt bias, higher equity-ratio requirements would be a bad idea, because they would decrease banks’ Return on Investment (ROI), and hence their value. Think of it this way: Suppose I invest $50 million in a bank, and the bank gets another $50 million in loans, and buys $100 million in assets, which appreciate, over the year, to become worth $120 million. The bank needs to pay back $55 million to its creditors ($50 million plus 10% interest), but the other $65 million is all mine. I make a 30% ROI, even though the bank made only a 20% return on its investments, because the bank was levered up. If it weren’t so levered up, I wouldn’t make as much. If the bank had funded all of its assets with a $100 million investment from me, then I would only get a 20% ROI.

And this is definitely, obviously true — when a company is doing well, leverage multiplies the amount it can return to its shareholders, particularly when interest rates are low. The problem is, when the company is not doing well, leverage multiplies how much the shareholders get hurt. There’s a formal mathematical expression of this idea which proves that (in the absence of tax biases), the capital structure  of a company is irrelevant to its value. The math is hard to express, but here’s an easy way to think about it: Suppose a company has a very reliable business model, and so it’s thinking about levering itself up an extra two times, in order to increase the take-home ROI of its owners.  This isn’t a horrible idea, but it’s also not necessary, for a simple reason: If the investors have faith in the company’s reliability, then they could just lever their own investments in the company up, taking out debt to increase their equity stakes, which would have the exact same effect on their take-home ROIs. So the debt-equity capital structure/ratio is irrelevant to the company’s value to its shareholders — it just shifts around the risk.

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One last quick note: A bedeviling misconception is the language that suggests that higher equity-ratio requirements mean that banks will have to ‘hold’ more equity, which will decrease their ability to lend, hence the supply of credit in the economy. This is totally insipid and false. Banks’ loans are assets — equity vs. debt are the way of financing those assets. Banks do not ‘hold’ equity. As soon as I invest in a bank, it can lend that money out. Banks ‘hold’ reserves as the Federal Reserve — but this is not at all affected by, and has nothing to do with, their equity. Admati’s proposals have nothing to do with how much cash banks have to keep in the bank.

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So here’s a three-step process to make our financial system ten times as safe as it is right now:

(1) Get rid of the debt bias in the U.S. tax code.

(2) Require banks to have equity ratio requirements of 20%. An easy and orderly process for getting banks to reach this level would be to forbid them all from paying out dividends (i.e., requiring them to reinvest all of their earnings) until they reach that level.

(3) Let banks make all the risky investments and chase all the profits they want — and next time their bets don’t work out, let their shareholders, and not the U.S. taxpayers of the financial system as a whole, bear the cost.

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4 thoughts on “Anat Admati’s simple proposal for stopping financial crises: Target debt, not assets

    • Hi Brian,

      Yes, a fuller treatment of the financial crisis would go more into depth about derivatives. But my very quick answer is just that derivatives contracts are particular kinds of financial assets (which were, in the financial crisis, crucially tied to the housing market), and so the basic idea here — of requiring banks to have more equity so that they are more robust to any decline in the value of their assets — applies to the problems associated with risky derivatives.

      Best wishes,
      M.

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