We were all caught naked
IPE hosted Stanford Business School’s Anat Admati this month, in town promoting The Bankers’ New Clothes, the well-received book she co-wrote with Martin Hellwig of the Max Planck Institute.
She argued passionately that highly-leveraged banks pose systemic risks, borne by society and that the 3% equity-to-assets level suggested under Basel III is inadequate – it should be 20-30%.
The banking industry’s argument that forcing them to ‘hold’ more equity will constrain lending she condemned as disingenuous. Saying you ‘hold’ equity makes it sound like a reserve, and if equity is the lowest-risk capital then ‘holding’ it must constrain banks’ ability to take risk, right?
Bankers seem to think this nonsense is technical enough to pull the wool over most people’s eyes but pension funds, with their own prudential rules, are unlikely to fall for it. They understand the game. But Admati suggested that they do need to think harder as providers of funding for banks.
Banks say that the return on equity investors require makes the cost of equity capital much higher than the cost of debt, and that 30% ratios would raise the bar for lending impossibly high. Admati counters that more equity makes the system less risky and therefore the required return on any individual bank’s equity lower.
Investors might be getting the message. Compare the price-to-book ratios of US banks that have pressed ahead with de-leveraging with those of Europe’s laggards. Wells Fargo is on 1.4 times, Goldman Sachs is on 1.1 times and JPMorgan 1.0 times, while Deutsche bank, BNP Paribas and SocGen all languish between 0.55 and 0.75 times.
But even 1.4 times seems low against the 2.5 times book that investors were prepared to shell out for bank equity in 2006 – and that was before all those rubbish assets were written-down. While the stuff banks do has become less risky, investors have priced them for more risk – because the risk that remains has been shifted more decisively from taxpayers to providers of capital.
We can see that this is about a change in exposure to risk rather than the nature of the risk itself because it is happening across the entirety of banks’ capital structures, not just in equity: the spread between subordinated and senior bank paper has halved since October 2012 as senior bondholders recognise that they can no longer use innocent civilians as human shields.
So banks’ cost of capital has shifted upwards, to reflect a more equitable, less systemic allocation of risk. To those who worry about this ruining their bank investments, Admati says simply: “So, how were your portfolio returns over the past five years?”
But on reflection, isn’t the answer to that: “Actually, all things considered, not bad”? Pension funds, just as much as banks and every capitalist, have been bailed out by government and central bank liquidity since 2009. So while it is difficult to argue with Admati’s analysis or ethics, she might find it difficult to get investors to cheer about settling for lower returns while apparently being exposed to more risk.