It is broadly accepted in the academic community that state protection of banks is a primary cause of banking crises. But efforts to remove such protection through regulatory reform must be undertaken carefully. An adequate approach will balance the benefits of increasing the required proportion of equity capital to be held by banks with the associated social costs of reduced lending to the economy.
The author reviews The Bankers’ New Clothes (Admati and Hellwig 2013), which discusses ways to deal with the issue of bank protection. He agrees with the underlying theme of Admati and Hellwig: State protection of banks is a major contributor to crises and there is a need for regulatory reform. Admati and Hellwig’s main proposal is to force banks to hold more of their capital in equity so that shareholders, instead of taxpayers, will bear most of the downside risk of bank losses.
Admati and Hellwig, the author argues, do not fully account for the costs and uncertainties associated with dramatic increases in the proportion of bank equity capital.
Banks that raise equity have other costs (and benefits) associated with capital structure choices that are only indirectly related to investors’ expected returns. This view is contrary to Admati and Hellwig’s argument that the risk-adjusted cost to banks of their capital structure can be equated with the risk-adjusted returns expected by investors.
The difference in views is driven by two key factors. First, potential differences between management’s and investors’ views of future earnings potential mean that equity offerings are associated with significant average market reactions. Second, high equity ratios may insulate managers from market pressures and thus reduce their efficiency.
In addition, a sustained reduction in lending can create a cost to society associated with increases in banks’ proportion of equity capital. Recent studies have shown that in the United Kingdom, a 1% increase in the required equity ratio reduces the supply of lending to domestic nonfinancial borrowers by about 7%. The author argues that although some reduction in lending may be desirable, the sustained reduction in lending ultimately slows down economic growth.
How Is This Research Useful to Practitioners?
The author aims to refine and contribute to the ongoing debate on regulatory reform to make financial systems more stable following the Great Recession. He highlights aspects of this conversation that have not yet received enough discussion—namely, the potential social costs of increasing capital ratios.
This article is most relevant to regulators and politicians who are currently involved in such efforts, but researchers and investment professionals focused on the finance industry will also find it useful.
How Did the Author Conduct This Research?
The author reviews The Bankers’ New Clothes and draws on such recent academic research on banking regulation, risk, and governance as Laeven and Valencia (International Monetary Fund working paper), Calomiris and Nissim (Columbia Business School 2013), Calomiris and Herring (Journal of Applied Corporate Finance 2013), and Laeven and Levine (Journal of Financial Economics 2009).
Two key elements are contributed to the ongoing banking regulation reform discussion. First, the potential social costs of increasing the proportion of equity capital are clearly explained. This aspect is relevant but has not received enough attention in the post-crisis banking regulation reform debate.
Second, the author introduces what I consider to be the elements of a good framework for discussing the proportion of equity capital that would be reasonable for banks to hold within a certain economy.