Monday, 14 December 2015

FT article says bank capital is expensive – it’s not.

This Financial Times article repeats the myth that bank capital is expensive. As the author puts it, “New regulations mean all banks must hold more equity, and that means they have to earn higher profits to keep return on equity at the levels investors demand.”

Seems it’s necessary to keep pointing out the fallacy in the latter point, so here goes.

Shareholders only demand a higher return than debt holders (i.e. bondholders and depositors) because shareholders get a hair cut FIRST when problems arise. I.e. it’s only AFTER shareholders have been wiped out that bondholders have a problem.

Ergo if the bank’s capital ratio is say doubled, then the extent of that “first hair cut” problem per share is HALVED. Ergo the return shareholders will demand for undertaking risk is halved. Ergo if the capital ratio is doubled, there shouldn’t be any effect of the total cost of funding the bank.

I get the distinct impression from the above quoted sentence that the author (Laura Noonan) doesn’t get that point, because she talks about “keeping the return on equity at” a particular level.

To illustrate the point another way, suppose there are two banks which are identical except that one is funded entirely or almost entirely by debt, and the other is funded entirely or almost entirely by equity.

The return demanded by both types of bank funder will be the same in that they’re both parting with savings rather than spending those savings. They will also demand a return in respect of risk.

But the risk of the bank going under is the same in both cases given that the riskiness of the banks’ assets is the same in both cases. Thus the chance of shareholders and debt holders being wiped out or losing X% of their money is the same in each case.

So shareholders and bondholders will demand the same return for parting with savings, plus they’ll demand the same for accepting risk.

The only possible escape from the above argument is that bondholders UNDERESTIMATE risk. That is the more naïve bond holders may be under the impression that £X of freshly issued bonds means the bondholder is guaranteed to get £X back when the bonds mature.

That however is not a strong argument for funding banks via debt because it involves taking advantage of peoples’ ignorance or naivity.

As distinct from the latter “naïve” reason for thinking bondholders will get their money back, there is a more sophisticated reason, namely the calculation that governments will not in practice let bondholders be ruined come a bank crisis. That calculation paid off hansomely in the recent crisis. That is, large bondholders are often personal friends of politicians and regulators. And one doesn’t want to ruin people one regularly meets at cocktail parties does one?

The morality of that reason for bonds being a cheap way of funding banks does not stand inspection, of course.

And finally, Google is funded 90% by equity. And as we all know, Google is a total failure. A complete basket case…:-)    

Incidentally, I got that information about Google from a video by Anat Admati.

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