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Bankers find more equity “expensive” because it transfers to them downside risk that would otherwise be borne by creditors or taxpayers. For the economy, more equity for banks is a great bargain, creating a safer and less distorted system that serves us all better.
On the other hand, more equity would reduce banks’ “return on equity”. Should we care? With more equity, each dollar invested in the equity is subjected to less risk. In a well-functioning financial market, this means that equity requires less compensation for risk. In banking as elsewhere, raw return on equity, unadjusted for risk, measures nothing relevant, not even shareholder value. Targeting high returns by choosing little equity may increase bankers’ bonuses and the value of their government subsidies, but does not serve the public good.
William Isaac, chair of Fifth Third Bankcorp, and Richard Kovacevich, former Wells Fargo chief executive, propose using subordinated debt to absorb losses. Does debt provide “market discipline”? Certainly no such “discipline” was evident in the run-up to the crisis, when banks relied on enormous amounts of debt and little equity. Most non-bank companies are funded with 70 per cent or more equity, without resorting to high leverage as a form of governance. Perhaps bankers can learn from them how to be more disciplined. After all, even with all of their debt and subsidised funding, the banks haven’t done so well for their shareholders recently, and certainly not for the economy.
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