Bank leverage, Cyprus and the lessons of the crisis
“The final banking crisis, which terminated in the banking holiday early in March 1933…” So begins a dark passage in Milton Friedman and Anna Schwartz’s Monetary History of the United States, which last Friday arose from ancient slumbers in the eastern Mediterranean.
The turmoil sparked by the proposed tax on Cyprus bank depositors makes it a perfect time to reflect on the responses to the financial crisis. The Bankers’ New Clothes (Princeton University Press) is a book that lays out the problems in banking revealed by the crisis and asks how to solve them. The authors, Anat Admati and Martin Hellwig draw upon accounts of the crisis (including mine) and come up with some clear prescriptions based on what they see as the biggest problem – that banks are over-leveraged. This problem is the wellspring of systemic risk, Admati and Hellwig argue, because wafer-thin equity means that bank asset problems quickly become bank debt problems, driving contagion because of banks’ liquidity needs and their linkages to one another.
A key issue is the cult of return-on-equity which is the mechanism by which senior bankers justify keeping their institution’s equity levels as small as possible. High ROE is good, trumpeted bankers such as Deutsche Bank’s Josef Ackermann and Barclays’ Bob Diamond. In fact, it’s about as good as a chemical factory that pollutes your local river to make a profit. Force banks to hold a lot more equity, and in effect you have cleaned pollution out of the financial system.
Now this insight about dangerous leverage and ROE isn’t itself new. Bank of England monetary policy committee member David Miles has been making the point for a number of years. Back in June 2011, I published an interview with Anthony Watson, non-executive director at Lloyds Banking Group and chair of the firm’s compensation committee in which he said:
“I would argue that it’s not actually bad for banks to be less profitable. If you drive ROE down to more sensible levels, in line with the economy as a whole, banks can still be worth more because
the market perceives them as being less volatile and is therefore prepared to value them more highly. But you have to make a judgement about that because lower profits should mean lower bonuses, and many bank CEO s tend to be too arrogant to listen to such arguments”.
As Admati and Hellwig demonstrate, the fact that the ROE cult and the leverage problem hasn’t been addressed since the start of the crisis is a testament to the power of banking industry lobbyists to obfuscate the issue. Their book serves as a manual for refuting banking lobby arguments and that alone makes it an invaluable text.
The unique ability of banks to borrow cheaply is the fuel that drives leverage and that brings us back to Cyprus bank depositors. Admati and Hellwig give a good explanation of the role of government subsidies in making debt cheap, and no form of bank debt as considered as sacrosanct as deposits. Threaten the safety of deposits, the arguments go, and the entire banking system is threatened (there’s been a fair bit of commentary like that in the past few days).
Admati and Hellwig’s solution to overleveraged banks is to force them to hold more equity – between 20 or 30 percent of their assets which is an order of magnitude bigger than the equity typical banks have today. The problem is that even if hobbled Basel rules required that kind of equity cushion, many European banks don’t have enough time to raise the capital. With today’s equity levels, and with doubts about the quality of their balance sheets, these banks are barely solvent (loan accounting rules contributed to this zombie bank problem as I discussed here).
If you believe that it’s not the job of central banks to bail out insolvent banks under the guise of emergency liquidity measures, then there are only two alternatives when the probable value of a bank’s assets are less than its liabilities: either a government injects equity (and perhaps seeks its own bailout to pay for it, like Ireland did) or creditors of the bank must lose money. Owners of unsecured bank bonds are one category of creditor in the firing line. However, what happens if these bondholders are insignificant compared with depositors, as is the case in Cyprus?
The message of books like the Bankers’ New Clothes is that it’s time to take a much less sentimental view of deposits. They are no more than a form of debt, and institutions such as companies, local governments and banks – as well as wealthy individuals – invest in deposits in an unsentimental basis, making judgements about risk and reward. Banks such as Societe Generale, Barclays and Deutsche Bank similarly use deposit funding to access leverage with a view to maximising returns on equity for their shareholders while taking the risk that depositors might suddenly ask for their money back.
What about non-wealthy individuals who need a place to keep their savings? The lesson of the Great Depression and the bank holidays of 1933 was the social importance of retail deposits required some kind of government guarantee, at least up to a certain limit. However, if all deposits are perceived as sacrosanct – or implicitly guaranteed – then Admati and Hellwig would argue that such protections amount to a hidden government subsidy. Bankers are very good at sniffing out such subsidies and gambling that their bluff won’t get called.
While I have no idea how the volatile mix of Cypriots, Russians and Eurocrats will resolve this crisis, one useful outcome of the ‘Cyprus precedent’ is that the value of such subsidies is now up for discussion.