What’s wrong with the banks?

In the 19th century banks funded themselves with 40% to 50% equity. In 2007, the US banking industry’s equity to asset ratio was 3.8 percent. For the 10 largest banks it was only 2.8 percent. What had happened?

The reason for the drastic decline in capital ratios during the 20th century is simple: since the Great Depression bank debt has been explicitly or implicitly guaranteed by the government. If creditors of a bank will be repaid regardless of the condition of the bank, they stop worrying about the condition of the bank. In particular, they will give the bank a discount on the cost of the funds it borrows and will not demand compensation for a lower capital ratio (i.e. a higher probability of bankruptcy).

In short: the government guarantee is a massive subsidy of debt financing. And minimizing equity to asset ratios maximizes the value of this subsidy to the banks’ shareholders.

The problem is that a razor-thin capital ratio creates perverse incentives for a bank’s investment decisions.

Consider the following example:

A bank is funded by 3 billion of capital and 97 billion of debt. The bank’s management can choose between two alternative strategies:

  1. Strategy A: The bank invests the 100 billion in relatively secure government and company bonds. After one period the return will be either 110 billion or 100 billion (with a probability of 50%, respectively).
  2. Strategy B: The bank invests the 100 billion in US subprime mortgages. After one period the return will be either 65 billion or 125 billion (with a probability of 50%, respectively).

In order to keep things simple, we normalize the interest rate on debt to 0%. Then the different stakeholders’ payoffs for the two possible strategies are given as follows.

Payoffs for strategy A (in billions):

creditors shareholders overall
Investment 97 3 100
return if lucky 97 13 110
return if unlucky 97 3 100
expected profit 0 5 5

Payoffs for strategy B (in billions):

creditors shareholders overall
Investment 97 3 100
return if lucky 97 28 125
return if unlucky 65 0 65
expected profit – 16 11 – 5

 

Note that strategy A is the efficient strategy because it maximizes the expected return from lending. However, by following an inefficiently risky business model (strategy B) the bank can increase the expected profits for its shareholders. If we assume that the bank’s management acts in the interest of the shareholders, it will choose strategy B.

In order to rein in on the perverse incentives created by deposit insurance (which is, of course, not insurance in the true sense of the word but simply a government guarantee) and other more implicit guarantees for bank debt (e.g. in the case of institutions deemed “too big too fail”) , governments around the world have been creating an ever-growing mountain of regulations.

Already before the financial crisis, the banking industry was the most heavily regulated sector in the economy. However, thousands and thousands of pages of regulations are not able to change the perverse incentives introduced by government guarantees for bank debt.

And make no mistake about it: these perverse incentives underlying the banking industry will lead to further crises.

 

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