22 May 2017

Financial Times: Five suggestions for avoiding another banking collapse

Larry Summers highlights three facts that seem to be in substantial tension with the widespread view that banks are far safer now than they used to be because they are far better capitalised.

This statement from Bank of England governor Mark Carney is typical: “The capital requirements of our largest banks are now 10 times higher than before the crisis. . . . This substantial capital and huge liquidity give banks the flexibility they need to continue to lend…even during challenging times.”

First, there is distressingly little evidence in favour of the proposition that banks that are measured as better capitalised by their regulators are less likely to fail than other banks.

Second, financial logic embodied in the celebrated Modigliani Miller theorem and suggested by common sense holds that substantial reductions in leverage, if achieved, should be associated with reduced volatility, reduced sensitivity to shocks and lower risk premiums. His paper examines a comprehensive suite of volatility measures including actual volatility, volatility implied by option pricing, beta, credit default spreads, preferred stock yields and earnings price ratios. While each indicator has associated ambiguities, it is striking that none suggests a major reduction in leverage for the largest US financial institutions, large global institutions or midsize domestic institutions.

Third, the ratio of the market value of banks common equity to its risk-weighted assets provides a market based measure of its leverage. Of course, the market value of equity overstates true capital because of limited liability: if assets rise in value there is no limit to how much shareholders can ultimately receive; but there is a zero lower bound on what shareholders receive.

Mr Summers is more confident that these observations need to be reckoned with in thinking about financial stability than he is in any particular set of explanations, much less policy conclusions. Here, though, are some observations suggested by his findings:

• First, it is essential to take a dynamic view of capital.
• Second, a crucial challenge for financial regulation going forward is assuring prompt responses to deteriorating conditions that do not set off vicious cycles.
• Third, regulators need to be attentive to franchise value.
• Fourth, bankers may be more correct in their concerns about increased costs of capital and its effect on lending than economists usually suggest.
• Fifth, it is high time we move beyond a sterile debate over more or less regulation.

Full article on Financial Times (subscription required)

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