Wednesday, August 28, 2013

The Problem with Leverage Ratio Requirements

Nothing panders to the masses better than apocalyptic prophecies that banks are on the verge of kick-starting another global financial crisis. 

Anat R. Admati, a career professor of finance and economics at the Stanford Graduate School of Business, and co-author of “The Bankers’ New Clothes: What’s Wrong With Banking and What to Do About It” is at it again in the New York Times suggesting that “we’re all still hostages to the big banks.”

No.  We’re not.

The opening paragraph suggests that banks have “blocked essential reforms at every turn” and that “our leaders have caved in.”  The facts suggest otherwise.  Sure, the banking industry, just like all industries, lobbies rule makers to ensure that new proposals achieve the intended goal without negative unintended consequences.  But to suggest that banks have somehow skirted new rules is comical. 

In fact, the Dodd-Frank legislation alone adds over 400 new rules that all financial entities must follow.  185 of those rules have been written to date, totaling over 5,300 pages.  It has been estimated that these 185 rules will cost the private sector more than 24 million man hours each year to comply.  24 million man hours equates to roughly 12,000 full time employees, and given the complexity of the rules, many will need to be highly paid lawyers, accountants, consultants and IT resources.  Assuming a conservative $100,000/yr annual cost (compensation, benefits, office space, etc.) of these additional employees, the 185 new rules alone could sap well over $1 billion a year from the capital bases of the financial industry in direct costs, and multiples of that in opportunity cost.  Extrapolate that out to 400 rules and we’re north of $2.5 billion per year. 

This doesn’t sound like “banking lobbyists have blocked essential reforms at every turn.”

After this whopper of misdirection, the article starts on the predicable trope of suggesting magical regulatory reforms that will save the world from the big, bad banks.  The reform du jour is punitive leverage ratio requirements.  A leverage ratio is simply total equity divided by total assets. 

We’re provided with scary sounding facts like "JPMorgan Chase’s $2.2 trillion in debt represented some 91 percent of its $2.4 trillion in assets” and “healthy corporations rarely carry debts totaling more than 70 percent of their assets” and “the six largest American banks collectively owe about $8.7 trillion.”  

Based on these scary sounding facts, Admati notes that “nothing suggests that banks couldn’t do what they do if they financed, for example, 30 percent of their assets with equity (unborrowed funds) – a level considered perfectly normal, or even low, for healthy corporations.”

We beg to differ. 

The biggest flaw in this solution is that simple leverage ratios (the percentages quoted by Admati) reveal almost nothing useful to assess the risk inherent in an institution.  A bank with $1 billion in equity and $10 billion in assets can achieve the same simple leverage ratio regardless whether those assets are the nothing but the safest US Treasury Bonds or all risky subprime mortgages.  To ignore the riskiness of the assets is nonsensical and renders a simple leverage ratio ineffective in assessing the danger a bank poses to the financial system.

Let's assume it’s possible to convert large portions of the banks debt financing into equity financing.  To meet a 30 percent leverage ratio requirement, the six largest banks alone would need to raise $2.3 trillion of equity capital.  This is roughly equal to 25% of the total market capitalization of the S&P 500, and roughly the size of 150 Facebook IPOs. 

Where is this money coming from?

Could the big banks raise enough equity financing to meet a 30 percent leverage requirement?  Doubtful, but even if they could we need to understand the consequences of this requirement.  Is the “safety” of meeting a draconian leverage ratio requirement worth the costs?  No.

Investors demand a higher rate of return on equity financing (owning a piece of the entity and a claim on future earnings) than they do for debt financing (contractual right to future payments), and rightfully so.  In a world where leverage ratios need to increase by a factor of six, margins must also increase proportionally to maintain shareholder value and remain competitive against investments in other industries.  How can a bank increase its equity base while also maintaining its return on equity? 

Higher margins. 

How can banks increase margins?  They can 1) reduce expenses, mostly by avoiding loan losses –best accomplished by restricting lending to the only the most creditworthy individuals and businesses and/or 2) increase revenues by charging more for services and credit. 

Remember fees on checking accounts?  Fees to use an ATM?  14% mortgage rates?  20% down payment minimums and other strict qualification criteria? 

Given that the health of our banking system is consistently underestimated, and our faith in government regulatory bodies is consistently overestimated, we posit that taxpayers would be hurt more by increased fees, elevated interest rates and decreased credit availability then they would be by the possibility of a repeat financial crisis caused by overleveraged banks.

Once again, half-baked op-ed’s continue to misinform readers by providing populist opinions that fail to consider the real life consequences (often unintended and counterproductive) of such opinions.  


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