Since the Great Financial Crisis began on August 9, 2007, I have said the focus on bank capital in the absence of transparency is an exercise in mental masturbation. In a recent speech on banking reform since the crisis began, Sir John Vickers gave an excellent example of why this is true:
The leverage question is one of the most fundamental issues for a market economy. On its answer there is a great divide.
The general (albeit not universal) opinion expressed by those in the financial sector – regulators, not just banks – is that reform since 2008 has got us to about the right place. Banks generally can have leverage of 30 or so, and the largest institutions 25 or so. (The US limits leverage more than the global norm, but there are accounting differences.) The authorities now, we are told, “are focused on not increasing overall capital requirements across the banking sector. In short, there will be no Basel IV” (Carney 2016, emphasis added).
But the general (ditto) opinion among economists outside the financial sector is that banks should be required to have at least twice as much equity capital relative to their exposures as the prevailing regulatory settlement. To say twice is indeed to understate things. A truly formidable group of economists with great expertise in finance, Nobel laureates included, wrote to the Financial Times in 2010 to criticise Basel III (Admati et al 2010). For them, at least 15% of bank assets should be funded by equity – “the social benefits would be substantial … and the social costs would be minimal, if any”. On that view, Basel III allows four times too much leverage. For Mervyn King a 10% equity base – three times Basel III – would be “a good start”.
So one group or the other, if not both, would appear to be wrong by a large margin, on a policy question of deep importance.
So here is a theoretical debate that will change nothing.
Allow me to point out that there is a much more important group than either financial regulators or economists who aren’t allowed to weigh in on the discussion of how much leverage banks can have. That group is investors.
Please note if banks provided disclosure, the entire discussion of leverage would be a mute point.
With an ability to assess a bank’s risk and return profile, investors would effectively set each bank’s leverage ratio. Investors would do so through the return they demand to be an unsecured creditor and/or shareholder.
If a bank is highly leveraged, investors will recognize it is riskier. As a result, investors will need to be paid more to buy the bank’s unsecured debt and will value the bank’s earnings at a lower multiple. This gives bank management a significant incentive to deleverage the bank. After all, what bank manager doesn’t want their stock to go up.
When banks provide transparency, we very quickly find out how much leverage investors will tolerate knowing they will lose their investment if something goes wrong. And investors know they will lose their investment because regulators will step in as soon as there is trouble and liquidate their investment.
The investors’ choice of leverage ratio is the only one that matters as they are the only ones who have skin in the game.