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In The Bankers' New Clothes: What's Wrong with Banking and What to Do about It (2013), Admati & Hellwig recommend much higher equity requirements:

Requiring that banks’ equity be at least on the order of 20–30 percent of their total assets would make the financial system substantially safer and healthier.

In contrast, under Basel III:

Banks’ equity can still be as low as 3 percent of their total assets.

Admati & Hellwig make some persuasive arguments. However, I am wondering:

What are the costs or trade-offs of requiring banks to have higher equity?

Admati & Hellwig repeatedly claim that there are no costs or trade-offs whatsoever (see quotes below). But if so, why wouldn't they recommend even higher equity ratios like 50% or even 100%? Why stop at 20–30%?

This leads me to think that there must be costs or trade-offs which they haven't mentioned. However, I am not sure what these are and hence my question.

if banks have much more equity, the financial system will be safer, healthier, and less distorted. From society’s perspective, the benefits are large and the costs are hard to find; there are virtually no trade-offs. ...

the view that there are significant trade-offs is flawed ...

long-term benefits of much higher equity requirements are large, and the costs are hard to find. ...

Best of all, these many critical benefits of significantly higher equity requirements could be obtained at virtually no cost to society. Taxpayers would save on subsidies, and the public would benefit from a more stable and healthier financial system. There are therefore no trade-offs associated with this approach. Society would obtain large benefits for free. [Emphasis added.]

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If banks are forced to hold 20-30% of their assets as common equity, their cost of capital is much higher. This is because the expected return on equity needs to be close to other industries, and that generally is much higher than interest rates. Typical targets for return on equity are around 20%, even in the modern low interest rate environment.

The result is that banks are much less competitive versus non-bank finance, and so would lose market share. Since non-bank financial entities are less well regulated, the risk to the system would rise if they take over lending.

So the immediate question is: how exactly can regulators stop all risk migrating to non-bank finance? Considering the flexibility of contract law, that is not easy, since financing arrangements can be embedded into almost any commercial contract (e.g., accounts receivable). You cannot just look at existing non-bank financial practices, you need to deal with any new structures that pop up to take advantage of the situation.

Once that question is answered, we would then need to figure out how to get borrowing rates to be a relatively reasonable spread over government bonds, since the lending spreads have to cover the return on equity for 20-30% of the balance sheet.

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  • $\begingroup$ their cost of capital is much higher -- according to Admati & Hellwig, this is one of the arguments that bankers like to give but is simply false. They spend a great deal of their book combating this claim. See especially their Ch. 7. Perhaps their arguments are wrong, but you'd have to explain why. $\endgroup$ – user1180576 Mar 14 at 1:59
  • $\begingroup$ Here's one of their working papers that is freely accessible and directly addresses this particular claim that they consider to be nonsense. $\endgroup$ – user1180576 Mar 14 at 2:14
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    $\begingroup$ They might argue that, but I have no evidence that any banker would believe them. If you want to debate their claim, you should probably pose that as a new question. My answer is based on standard financial theory. $\endgroup$ – Brian Romanchuk Mar 14 at 19:36
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    $\begingroup$ To clarify: the objective of this website is to provide Q&A, and not be a forum for arguments that go on forever. The moderators will just purge lengthy arguments that happen in the comments. $\endgroup$ – Brian Romanchuk Mar 14 at 19:38

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