Many bankers insist that more equity on bank balance sheets
would crimp their ability to lend. Sure, they will impose
rigorous covenants on nonfinancial corporate borrowers that
operate with less than 40 percent equity, but 13 percent for
the banks own looks more than ample to JPMorgan Chase
chairman Jamie Dimon. Of the extra cushion, he says, this
is capital that we dont need.
Nonsense, says Anat Admati, the George G.C. Parker professor
of finance and economics at Stanford University. Who are
bankers kidding? It is high leverage, flawed regulation and
compensation structures in banking not more equity
that curtails lending capacity.
Admati is a co-author of Debt Overhang and Capital
Regulation with Stanford University colleagues Peter
DeMarzo and Paul Pfleiderer and Martin Hellwig from the Max
Planck Institute in Bonn, Germany. They published the research
paper in March, a sequel to earlier research. Their recent
conclusion: High equity requirements for banks bring
about large benefits at essentially no relevant social cost.
Banks funded with much more equity would be able to serve the
economy better, without subjecting it to excessive risks and
Institutional Investor contributor Steven Mintz
spoke recently with Professor Admati about the case for more
equity on bank balance sheets.
What persuades you and your co-authors that higher
equity requirements would be so beneficial?
Three key reasons. One, better capitalized banks can absorb
losses without creating system-wide financial instability.
Second, banks with more equity are less burdened by debt
overhang so they can raise funds more easily for new loans. And
three, higher equity requirements might give pause to banks
before they embark on riskier investments that fueled the
financial crisis. In addition to requiring too little equity,
flawed current regulations use a system of risk weights to
specify the equity requirements. The risk tier weighting system
favors marketable securities and other structured investment
and derivatives over lending to productive companies in the
real economy that can help the economy grow.
What about market consequences if banks must add
equity to their balance sheets?
It sounds counterintuitive. Shareholders and managers of
highly leveraged banks, those whose investments are
concentrated in the banks, resist leverage reduction even if
the banks total value might increase. High leverage works
for bankers whose bonuses are pegged to return on equity, but
not for the rest of us. Reducing leverage benefits existing
creditors and taxpayers who ultimately guarantee the debt. When
high leverage rewards bank managers but exposes third parties
to risk, or externalities, you get social inefficiencies.
Thats because most shareholders own bank stocks in
diversified portfolios and they pay taxes. If undercapitalized
banks trigger another financial crisis, the vast majority of
shareholders are likely net losers.
What about other adverse consequences that bankers
Banks say their costs will go up, but they give fallacious
reasons, never mentioning that the key reason for any such cost
reduction is that their borrowing is subsidized through
guarantees and tax savings. There is simply no shred of a valid
reason banks should not be funded with 20 percent to 30 percent
equity. It would not hurt their ability to do anything for the
economy, while bringing great benefits.
Bankers cloud the issue. Equity is not idle cash. Equity is
held by shareholders and invested in loans and other
investments. Safer banks with more equity would add incentives
to write sound loans and reduce reason to favor risky
investments that increase bankers compensation but make
the financial system more fragile.
Why dont rule makers hear your
There is a combination of confusion and a form of capture
around the world. The crisis revealed failings of regulations
and enforcements, but it seems difficult to get effective
change. Flawed risk weights have allowed a huge buildup of
systemic risk. Banks, especially in Europe, failed on
investments considered safe by regulators. The politics is
complex. Many industries lobby, but no one as much as the
banking industry, and they seem to have an impact.
Regulators have some idea of the problem but they are afraid
of the industry. Models lull them and can be used as a cover.
They let banks pay dividends which deplete equity unnecessarily
and do not examine the issues sufficiently. On the outside
everything works so long as risk weightings and accounting
tricks conceal risk. But this remains a highly dangerous
How do you propose banks build equity when stock
prices are low?
The best way to increase equity is to stop payouts through
dividends or share buybacks. Id happily give up my
dividends to build up capital and a more stable banking