In 1840 equity funded more than 50 per cent of bank assets in the US, now it’s around 7 per cent. Banks as lenders would never lend to a business with such little equity, so why is it ok for them? And why don’t institutional investors have more of a voice about the extent of debt and leverage in the system? Professor at Stanford, Anat Admati, addresses the problem.
The banking system is fragile and dangerous, it distorts the economy and is dysfunctional; there is way too much leverage which is unnecessary and unproductive, and there are forces within that are self-destructing. Needless to say it’s a mess.
This is the dim picture painted for delegates at the www.top1000funds.com investment think tank by Anat Admati, professor of finance and economics at Stanford Graduate School of Business.
“It’s a system that’s essential to the economy but not supporting it, it’s not aligned,” she says.
“It’s fragile because there is an extraordinary amount of leverage and a reliance on a large amount of short-term debt. It lives on borrowed money and has liquidity problems. It consists of many layers of fragile institutions with an incredible amount of inter-connectedness and contagion mechanisms,” she says. “There is flawed and ineffective regulation, which makes it worse – off balance sheet commitments, shadow banking, OTC derivatives, risk weights, and the opaqueness of the system are all not helping.”
Admati, who in presenting to the institutional investors was straight off the plane from a Davos presentation, says because the system is so highly leveraged there are conflicts of interests between borrowers and lenders.
“There are very few people who benefit from this unhealthy system,” she says. “There are a few, mostly the managers of the banks that benefit, the rest are hurt from it and it has to be absorbed by the economy somehow.”
She says bankers love to borrow and resist leverage reductions but for society excessive leverage is expensive.
“We are shooting ourselves in the foot creating a fragile system by subsidising debt,” she says recommending regulators act now by mandating banks have between 20 and 30 per cent of total assets.
Basel III capital requirements of 4.5 to 7 per cent, but she says that these requirements are based on flawed analyses of trade-offs.
“Regulators have authority but lack political will,” she says. “This is a huge missed opportunity for reform. Financial stability doesn’t have a constituency in this world, institutional investors should have more voice.”
In 1840 equity funded more than 50 per cent of bank assets in the US. In the 1980s it was 25 per cent, and now around 7 per cent of US bank’s funding is equity.
She uses JP Morgan Chase’s balance sheet as an example. At the end of 2011 it had an equity market value of $126 billion, and equity book value of $184 billion and less than $700 billion in loans. Other debt, which is mostly short term, was valued at $1.8 trillion.
“People don’t appreciate the outrageousness of this.
“Banks as lenders would never lend to a business with such little equity, so why is it ok for them?” she says.
Admati, who was sitting on a panel in Davos with hedge fund manager Paul Singer and representatives from HSBC and Barclays, says it is hard to find people who say something about the banks.
But her recommendations for decreasing leverage, and increasing equity will have immediate benefits, she says.
It will reduce the likelihood of default, protect the economy from spill over effects and it shifts the downside risk from the taxpayer to the shareholders or also benefit from the upside.
“The big challenge to bank failure is that whereas banks live globally, they die locally.” ” she says.
Admati says that banks as corporations don’t need to borrow to fund.
“Central banks don’t understand banks are corporations that can fund with equity, they are blind to the impact of leverage on the system,” she says. “Political-will won’t change the system. The government wants banks to fund them, it’s all money politics, which is a general political problem in this country. The public has to demand a better system.”