Monday, April 22, 2013

Admati/Helwig on Banks and Too Much Debt

Here's a surprise, kindled by my Kindle and specifically by The Banker's New Clothes, the remarkable new reform proposal presented by Anal Admati and Martin Hellwig.  That is: the surprise is that when understanding themselves and their own finance, bankers are really a bunch of primitives, mired somewhere back in the 19th Century, unencumbered by any of the knowledge that helps us to understand financial markets today.
Start with the balance sheet, specifically debt and equity.  Back when rocks were soft, we tended to think that equity was "us" and debt was "them"--leading, inter alia to the egregious conceptual error whereby we let management deduct debt service as an expense before figuring taxes; contrast dividends, where we have to pay the tax before we pay the equity.

Actually, students still believe that.  But one  of the jobs of the finance teacher is to beat it out of them: to convince them that everything on the right-hand side of the balance sheet.  Interest is a return on assets; dividends are a return on assets.  In short, it is all capital.

This isn't fancy theory; this is every day stuff.  The odd thing is that the only people who don't seem to get it are the bankers, who persist in building their model around "capital" which means equity-and-not-debt; us versus them.

Which brings me to the remarkably simple thesis of the authors: banks have too much leverage: too little equity and too much debt.  The remarkably simple remedy: change the ratio; more equity and less debt.  The point is that equity is not a fixed charge.  You don't have  to feed the meter every six months or every year; indeed you don't   So equity is resilient; equity can roll with the risk, and thereby avoid the calamity of aught eight.

The authors support their argument with an admirably clear sketch of debt  in practice, its opportunities and hazards--had I had it on hand, I might have swiped it for students,.  Beyond the basics, they are still clear and mostly convincing, although they seem to be a little wobbly on just exactly how and why we find ourselves burdened with these distortions.   The real point seems to as simple as the core argument itself: bank debt comes decked out with an implicit subsidy so it's cheap.  The banks pass the government's money on to you--no, strike that, banks pass the money on to bankers in the form of fat pay packets and all the attendant perks   (you can pretty much skip the stuff about the tax subsidy to debt, and the phenom of banks that trade below book--they're both side issues, I think).

This is beguiling although I am not sure it goes all the way to making their point.  After all, equity gets its own share of government subsidy, so equity itself should be below-market cheap.  The more compelling reason seems to be that bank compensation is pegged to equity returns which, even if distorted, will nonetheless almost invariably exceed debt returns,.  So it doesn't matter how small the equity slice is: what does matter is the rate.

And now we come to the next point that nobody down at the bank seems to notice: the other reason those equity returns are so high is that equity is risky--the more debt, the higher the equity return, and the more chance the whole deal will plotz (heh).  You'd think that somebody down at the bank might have noticed.  But as somebody once said, when a man's living depends on not noticing something, he will not notice it.

At least I think that's how it work and I suspect that the authors, though a  bit more tentative, might agree.  But I can also think of at least two points beyond the basic framework that need attention.

One: the authors seem to take it for granted that a business with too much debt is too rigid.  They may  be right--there is a lot of evidence on their side.  Yet for entities other than banks, this alleged rigidity doesn't seem to be a problem.  When the business gets on the trouble, we toss the keys on the table; we cancel the old equity and rechristen the old debt.  Maybe there are good reasons why this won;t work for banks; or maybe we just don't try.

The other point is one that the authors probably understand perfectly well.  Thar is: they don't offer the slightest suggestion as to how we get from A to B: how we extract all these pointy fangs from the bankers' mouths and leave them less like an alligator, more like, say, a simple garden-variety snake.

1 comment:

MaysonicWrites said...

The "Just make them have more capital" solution sounds good, but:

See William K. Black's takedown of the Brown-Vitter attempt to do that.