Fear, greed and bank capital
Buildings should be strong enough to withstand storms and earthquakes. Similarly, banks should be able to remain upright after massive waves of losses. Engineers have a pretty good idea of how to make skyscrapers strong. The regulators and lawmakers who set the rules for big banks are still struggling, five years after the government rescue of many American and European banks.
Bankers and their defenders say that the struggle is over. The financial structures have been reinforced: deeper capital foundations, new supports added and weak materials removed. But many critics point out that the banks have not done the one thing necessary – to double or triple the ratio of shareholders’ equity to total assets. That is the only sure way, they say, to guarantee that large losses on loans do not threaten the ability of the institution to remain standing.
I think the critics are largely right. As economists Anat Admati and Martin Hellwig explain in their book, The Bankers’ New Clothes, the bankers’ almost instinctive aversion to equity protects bonuses and shareholders at the expense of the general public. Still, in my view banks have a more fundamental problem than poor capital structures. It is society’s unreasonable expectations of what they can accomplish.
The best way to make banks disaster-proof is to eliminate an irrational fear which makes banks too big and to resist the dangerous greed which makes them too brittle.
It is quite rational to fear a sudden banking system collapse, but economists and politicians are much too worried about a sharp decline in lending. While such a credit drought is always a possibility, right now the greater danger is from a continuing credit flood.
Regulators and economists pay attention to the supposedly meagre flow of credit to small businesses. That may be a problem – the evidence is mixed – but it pales before the excesses.
There is too much lending from one financial institution to another and too much public-sector borrowing for the sake of unjustifiable lower taxes or higher spending. Governments borrow wildly, while mortgages and consumer loans leave more families in precarious financial positions. National levels of leverage remain at record highs, even before considering the debt hidden in derivatives.
As for greed, it is easy to pick on bankers, but they have become a scapegoat. Everyone who puts money into banks is guilty. Shareholders want too high dividends, buyers of bank debt refuse to accept losses and depositors demand absolute safety. All of them want more than is reasonable. Banks should not squeeze vast profit out of the economy, and they cannot fully escape the real economy’s ups and downs.
What would banks look like without the misdirected fear and the nearly ubiquitous greed? They would certainly have more equity, but I think society would demand something more: a different banking system. I would suggest a three-part arrangement.
Start with purely transactional Narrow Banks. They take no risk, holding their funds in the electronic equivalent of mattresses. The need for such institutions is obvious, once the exaggerated fear of insufficient credit is removed. The money used for payrolls and bills should be safe and totally separate from the funds dedicated to the inherently risky business of saving, lending and investing.
Second come anti-greed institutions, Safer Banks. Unlike Narrow Banks, they make loans, but only relatively safe ones. They are tightly regulated, charge modest interest rates and promise depositors moderate returns. These promises can almost always be kept, but when they cannot, when literal or figurative tsunamis hit, the depositors will suffer. That risk should be made clear, perhaps by designating a small portion of the deposits as “risk shares” which offer variable returns.
Finally, there are Riskier Banks, which put money in riskier enterprises, offering more potential gains for depositors and investors who are willing to bear more potential losses. Today’s banks are mostly Riskier, but their business model – high default rates on loans, high interest rates for borrowers and high promised returns to some providers of funds – makes them liable to disastrous sudden collapse.
Regulators are improving their rescue techniques. However, it makes more sense to address the structural flaw. Riskier Banks should take much less risk on their own account. They should simply pass through a variable stream of payments from borrowers to depositors.
To keep the stream from excesses, loans with high interest rates should be replaced with more flexible products. Defaults would be rarer if payments varied along with some measure of economic activity: income, inflation rates or a collection of general economic indices.
The design of such flexible products is a job for financial engineers. Up to now, the profession has largely wasted its skills in modelling and analysis. Their products often encouraged reckless behaviour. The engineers could redeem themselves by designing sounder banks.