Anat Admati: Mending The Roof Of A Bankrupt Banking System

 |  Includes: FXE, JPM
by: QFinance

By Ian Fraser

Five years on from the start of the financial crisis, the debt overhang at the world’s banks remains terrifyingly huge. Balance sheets are liberally sprinkled with ticking time bombs that could explode at any time bringing down economies. Yet, despite the urgent need to focus on deleveraging, most senior bankers continue to reward themselves vast sums for policies that make the situation worse, warns Professor Anat Admati at the Stanford Graduate School of Business.

A paper titled "Debt Overhang and Capital Regulation," written by Admati along with Stanford colleagues Peter DeMarzo and Paul Pfleiderer and Martin Hellwig of the Max Planck Institute for Research on Collective Goods in Bonn, explores the conflict between the interests of management/shareholders and those of creditors/depositors that is tugging at the heart of banking, with a particular focus on who ultimately is bearing the downside risk.

In a recent New York Times op-ed focusing the recently announced $2 billion-plus losses at JPMorgan Chase (NYSE:JPM) following the speculative activities of the so-called "London Whale" Bruno Iksil, the writer Delai Ephron summarized this conflict of interest succinctly:

Ms. Ina Drew [who until recently ran JPMorgan’s so-called chief investment office, where the 'whale' worked], blamed for the loss, resigned. She earned roughly $14 million last year while Chase currently pays depositors as little as 0.01 percent on a savings account and charges as much as $35 a month for checking. She earned $14 million, and she didn't know what her job was: Don’t lose our money. Of course that was not really her job. Ms. Drew’s job was to make as much money as she could for the bank, which, under the guidance of Mr. Dimon, would pass on as little as possible to its depositors.

In their working paper the four academics put the problem rather differently. They write:

We show that debt overhang creates inefficiency, since shareholders would resist recapitalization even when this would increase the combined value of the firm to shareholders and creditors. Moreover, debt overhang creates an 'addiction' to leverage through a ratchet effect. In the presence of government guarantees, the inefficiencies of excessive leverage are not fully reflected in banks' borrowing costs. ... Private actors in the banking system have strong incentives to choose excessive leverage that is not only unnecessary, but is harmful to the ability of the system to serve the economy.

Admati believes that the only reason equity investors are willing to buy the shares of banks is because they don't even consider the dangers that thinly capitalized and therefore highly leveraged institutions present to the wider economy -- and therefore to the rest of their portfolios. And she believes that rather than make massive multibillion-dollar payouts made to managers (in salaries, bonuses, long-term incentive plans and other perks) and shareholders (in dividends) for increasing risk, banks ought to be resolutely focused on reducing leverage or pumping money into the "real" economy. However the trouble is, as Admati puts it:

Like a bankrupt homeowner who won’t repair his roof, shareholders and bank managers see no direct benefit in paying off their creditors to reduce leverage.

In the paper Admati, DeMarzo, Pfleiderer and Hellwig urge global regulators to pay far greater attention to the payouts that banks are making to shareholders and managers, and the consequences of these. They also argue that the Basel III proposals, first unveiled by the Basel Committee on Banking Supervision in September 2010, are insufficient and flawed. They are particularly critical of the system of risk weights used in the proposed regulation, arguing that these introduce still further distortions and inefficiencies, especially given that sovereign debt is, perhaps somewhat farcically given how Greek bondholders got their fingers burnt, still classified as "risk free" under Basel III.

The authors believe every country should treat the capital and liquidity rules prescribed by Basel III as a bare minimum and design better regulation that involves significantly higher equity requirements, even as high as 20%, or even more equity relative to total assets, compared to the 3% Basel III allows.

Admati’s proposals are echo those made of Robert Jenkins, a member of the Bank of England’s monetary policy committee, and by Andy Haldane, the BoE’s director of financial stability. Both Jenkins and Haldane have urged UK banks to scrap return on equity as a measure of success and adopt instead return on assets (RoA), which would give them a much learer picture of how well or badly they are doing.

Jenkins pointed out that, even as a most U.K. banks were racing toward disaster in 2006-07, they believed they were doing well as their return-on-equity was rising. Had they bothered to calculate or examine return-on-assets, they would have realised they were headed for disaster. Aside from the sumptuous treats of board lunches, their semi-comatose boards were being fed an entirely warped picture.

In a previous paper, Admati, DeMarzo, Pfleiderer and Hellwig afocused on the subsidies associated with debt, particularly those enjoyed by banks that are deemed "too big to fail." Admati said that governments that insist of giving banks near-blanket guarantees are doubling up on the perverse incentives.