17 January 2013

David Miles: Bank capital requirements - Are they costly?

There is a view that banks are using more equity capital – and relatively less debt – to finance the assets they hold, creating substantial costs so great as to make more capital unfeasible. This column argues that these costs are exaggerated, but that the benefits of having banks that are far more robust are likely to be large.

The ‘capital requirements are costly’ argument

So why do so many people seem to think that having banks use more equity is so costly? One reason is that some people seem to think that capital is money that is forced to lie idle, that it is ‘tied up’. This obviously makes no sense at all. Equity funding helps finance the acquisition of assets. It is a source of funding for bank lending in exactly the same way that debt is. You might think this is so self-evident that no one could ever believe the notion that requiring banks to use more equity is withdrawing funds from the economy. But I think you would be wrong, at least judging from the number of times you hear the view that higher capital requirements are sucking money out of the economy and starving firms and households of credit.

A rather more subtle argument is that, while in some circumstances equity is not an exceptionally costly form of finance for banks, today it is because bank equity is trading at a huge discount. One version of this argument is that because the ratio of the market value of equity to its book value is well beneath unity, a bank which raises equity is imposing huge costs on those that provide it. I find this argument hard to understand. One interpretation of the argument is that because the market value of existing equity sits well below book value, a bank that raises one pound of new equity and invests in new assets will immediately find that the market value of those assets will fall to well under one pound. But why should one believe that the management of a bank is doomed to repeat whatever historical mistakes have created a situation where assets acquired in the past are now valued at less that the cost of acquisition? Is not a bank manager convinced of this so pessimistic of their own ability that they are in need of therapy, or a change of career?

Another interpretation of the price to book argument is that it shows that required returns on new equity are very high. But a far more natural interpretation is that investors believe that existing assets on a bank’s balance sheet are worth less than their acquisition cost rather than that the required return on new investment is very high. This interpretation is consistent with the analysis on the latest Bank of England Financial Stability Report (Bank of England 2012):

“In June 2012, the market value of the four largest UK banks’ equity was around £90 billion less than the book value. This magnitude is similar to the difference between banks’ own estimates of the fair value of their loans and their book value at the end of 2011. Before the crisis there was little difference between these values. But since 2007, the fair value of UK banks’ loans has fallen significantly below the book value.

The fair value of loans should reflect the present value of expected cash flows. For example, expected credit losses, over and above current provisions or losses priced into loans, reduce the fair value of loans below their book value.”

One convincing argument

The argument as to why raising more equity capital is problematic for banks that I think makes most sense is that the benefit of extra capital may substantially accrue to those with debt claims, making it unattractive to new shareholders. This is a debt overhang problem:

• First, while it may help explain difficulties for banks in raising more equity it also means that failure to raise more equity is a huge obstacle to a bank being able to function properly. Not raising more equity would leave a bank with a cushion against losses too low to make it able to raise debt easily – that is precisely the debt overhang phenomenon in another guise.

• Second, one way to handle the debt overhang problem is to have some debt convert to equity. That is why regulators are surely right to think that having banks issue more convertible debt is one means to make them more robust.

Conclusions

What are the people that run banks really saying if they argue that it is very costly – even unfeasible – to use more equity funding? One interpretation is that this argument is an admission that they cannot run a private enterprise in a way which makes people willing to provide finance whose returns share in the downside and the upside. In other words, they are not able to convince people who will face the full consequences of their commercial decisions to provide funding. It is as if banks cannot play by the same rules as other enterprises in a capitalist economy – after all, capitalists are supposed to use capital. You might expect that if this is the assessment of many people who currently run banks, then they would not wish to proclaim it so loudly.

Full article

© VoxEU.org