Anat Admati at Treasury Conference on the Need for Leverage Regulation

Anat Admati at Treasury Conference on the Need for Leverage Regulation

Last week, Niskanen Center advisory board member and Stanford professor Anat Admati gave a presentation at a conference hosted by the Treasury Department. (You can see the slides from her presentation here.)

Her discussion addressed not only the disastrous effects of over-leverage and the myths that pervade our financial system, but also why financial institutions must have greater leverage regulation imposed on them during good times, based on the findings of her new paper co-authored with Martin Hellwig:

We take issue with claims that the funding mix of banks, which makes them fragile and crisis-prone, is efficient because it reflects special liquidity benefits of bank debt. Even aside from neglecting the systemic damage to the economy that banks’ distress and default cause, such claims are invalid because banks have multiple small creditors and are unable to commit effectively to their overall funding mix and investment strategy ex ante. The resulting market outcomes under laissez-faire are inefficient and involve excessive borrowing, with default risks that jeopardize the purported liquidity benefits. Contrary to claims in the literature that “equity is expensive” and that regulation requiring more equity in the funding mix entails costs to society, such regulation actually helps create useful commitment for banks to avoid the inefficiently high borrowing that comes under laissez-faire. Effective regulation is beneficial even without considering systemic risk; if such regulation also reduces systemic risk, the benefits are even larger.

Their rationale for why laissez-faire simply can’t work for the financial sector is based on the inability of lenders to discipline banks and the perverse incentives of shareholders to increase leverage.

The first is the inability of lenders (excluding ordinary depositors, who should also be considered lenders) to effectively monitor their debtors. Unlike industries in the non-financial sector, where generally speaking a few large lenders provide firms’ debt, financial institutions’ borrowing is financed by a large number of “small” (relative to the total amount borrowed) loans. This creates a collective action problem among lenders, who, instead of better monitoring a borrower’s risk, “will then ask for substantial collateral and for a high interest rate.” When more institutions lend to a firm, this creates a “dilution” effect.

The second line of attack has to do with the incentives of shareholders. Leverage allows firms to increase their return on equity, making borrowing an attractive proposition to shareholders. Even though their claims are subordinated to those of debtors, “it is never in the shareholders’ interest to use this opportunity to reduce indebtedness [but] it is always in the shareholders’ interest to increase the amount of debt in the funding mix.” (Emphasis in original).

This phenomenon, called “the leverage ratchet effect” is fueled by the preferential tax treatment given to debt, the loss of a firm’s default option when leverage is decreased, and the “dilution” of lenders when more money is borrowed. This happens even if increased leverage would lead to a decrease in the firm’s value.

Given these perverse incentives (on top of the implicit promise of bailouts should things go awry) it is necessary to mandate a minimum level of equity financing for banks. The Basel III reforms require a minimum of 3% equity financing, but after the accords, Admati and a number of other economists argued in a letter to the Financial Times the minimum should be at least 15%.

I didn't find this helpful.This was helpful. Please let us know if you found this article helpful.
By |2018-12-03T09:53:11-08:00December 3rd, 2018|Blog, Financial Regulation|