To date, the reforms under consideration by various governments including the U.S. do not address the core issue, which is that banks have too little skin in the game. It’s “other people’s money” with which bankers make their loopiest bets: to wit, federally insured depositors’ money, funds borrowed in global bond markets and $2 trillion-plus of taxpayer funds injected into banks to rescue them at the onset of a Great Recession triggered by the banks themselves.
The “animal spirits” of capitalists that John Maynard Keynes credited with economic vitality have less of a proper place in banking than in other fields. Serial failure is a badge of honour in Silicon Valley, for example, whose entrepreneurs pick themselves up, dust themselves off and try something new. Banks are at the other end of the spectrum, entrusted with the savings — often for retirement — of customers who cannot afford to lose that money.
The pallid reforms now under consideration, almost all of them opposed by the architects of calamity in the banking industry, include shrinking banks deemed “too big to fail” by breaking them up, which was the fate of Standard Oil and other “trusts” in the early 20th century.
There’s also talk of stripping banks of certain activities such as ultra-high-risk derivatives trading. Or perhaps we should limit bank lending to traditional borrowers — the function that has the most social utility — and restrict or forbid speculative investing by banks.
None of these “reforms” address the unique nature of banking which, unlike other businesses is wed to debt financing.
The likes of Apple Inc. and Magna International Inc., on the other hand, pride themselves on carrying no debt. Instead, they stockpile cash for a rainy day. They finance much of their operations out of retained profits rather than paying most of them out in dividends. For its first 20 years or so, Microsoft Corp. did not pay a dividend.
Banks, by contrast, flush most of their profits out as dividends, mostly to keep their stock prices — to which executive pay is tied — high and rising. In this way they forsake one of the cheapest types of funding, namely retained earnings that can be dipped into without incurring burdensome interest obligations.
Being almost entirely debt-financed and having little by way of retained-earnings nest eggs, banks are highly vulnerable when losses occur, as they inevitably do even at a prudently run bank. As such, “banks are not so much too big to fail as too likely to fail,” writes Slate political economy analyst Matthew Yglesias, “prompting disastrous financial crisis.”
Yglesias is one of many sage commentators, free marketers and small-government types alike, hailing the newly published book The Bankers’ New Clothes as perhaps the best-ever blueprint for substantive banking reform. Its authors are Anat Admati of Stanford Business School and Martin Hellwig of the Max Planck Institute.
Banks operate with microscopic capital reserves to cushion a great fall. Yet they are objecting to the international proposal that they rely on debt for no more than 97 per cent of their activities. Incredibly enough, an industry in charge of the world’s flow of money — including the international clearing system and the flawless operation of your ATM — has, comparatively speaking, less money on hand to cope with a crisis than the average household.
In a nutshell, Admati and Hellwig propose that banks fund 20 to 30 per cent of their activities from raising money with sales of stock, or equity. Equity needn’t be repaid. And it doesn’t require the payout of dividends, either, if banks choose from time to time to finance themselves internally by reducing or eliminating dividends. This reform would not only liberate banks as prisoners of debt obligations, it would bulk up retained earnings as a cost-free source of capital and provide a safety cushion when the banking world periodically turns upside-down.
Banks with a capital cushion of 3 per cent of assets are easily crippled by an unforeseen surge in loan losses — or would be if taxpayers didn’t rescue them. But with a capital cushion equal to 20 per cent or more of assets, enormous losses in all but the rarest cases could be sustained without external help.
The counter-argument is that this model of financing banks — which in fact prevailed prior to the 20th century — would trim the sails of lenders. They would have to work harder to win investor confidence in order to sell more stock than they’re accustomed to. Then again, this would make banks more accountable to the natural forces of capitalism. A poorly run bank would have a tougher time raising equity capital, and that’s as it should be.
What isn’t ideal is a status quo in which taxpayers indirectly subsidize the heavy indebtedness of banks, an inherently high-risk condition. Normal companies that burden themselves with unmanageable debt are inviting bankruptcy, so they generally don’t do it. A notable feature of the Great Recession is how few “real economy” corporations have gone under. They learned their hard lesson about debt-swollen balance sheets in previous recessions and entered the latest downturn with healthy ones.
No government will come to the rescue of McDonald’s Corp., and its management acts accordingly. Banks, by contrast, enjoy an implicit guarantee that they will not go belly up and renege on their debts because society cannot afford to let them do so. Governments have spent trillions of dollars injecting emergency cash into troubled banks, and have absorbed the bad loans of crippled banks forcibly merged into sounder ones. Remarkably, some megabanks are still racking up multibillion-dollar losses on errant derivatives and other high-risk investments.
This absence of harsh consequences for cupidity in banking encourages risk taking that borders on lunacy. Every decade or so there’s a banking crisis. Feckless lenders threw too much money at developing-world borrowers in the 1970s, then at overheated petroleum and commercial real estate markets in the 1980s, triggering a savings-and-loan (S&L) crisis that cost government billions of dollars to clean up. They fuelled the boom-bust cycle in dot-coms and telecom in the 1990s and most recently inflated the housing bubbles in North America and Europe in the 2000s.
In stubbornly refusing to accept, much less embrace, common-sense industry reforms, bankers seem determined to continue running what are effectively public utilities in the chief interest of lavishly paid executives and traders, largely oblivious to the interests of the larger society. As such, they are making the case that sound practices will have to be imposed on them.
Original Article
Source: thestar.com
Author: David Olive
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