Would you give money to a compulsive gambler who refused to kick the habit? In essence, that’s what the world’s biggest banks are asking taxpayers to do.
Ahead of a meeting of the Group of Seven industrialized nations’ finance ministers in Marseilles this week, bankers have been pushing for a giant bailout to put an end to Europe’s sovereign-debt troubles. To quote Deutsche Bank Chief Executive Officer Josef Ackermann: “Investors are not only asking themselves whether those responsible can summon the necessary willpower … but increasingly also whether enough time remains and whether they have the necessary resources available.”
Unfortunately, he’s right. As Bloomberg View has written, Europe’s leaders -- particularly Germany’s Angela Merkel and France’s Nicolas Sarkozy -- are running out of time to avert disaster. Their least bad option is to exchange the debts of struggling governments for jointly backed euro bonds and recapitalize banks. European banks have invested so heavily in the debt of Greece and other strapped governments, and have borrowed so much from U.S. institutions to do so, that the alternative would probably be the kind of systemic financial failure that could send the global economy back into a deep recession.
At the same time, bankers are campaigning against regulators’ efforts to address a root cause of the problem: Big banks’ addiction to excessive leverage, or to using borrowed money to boost their shareholders’ returns. In a recent flurry of letters to the Basel Committee on Banking Supervision, which is in the process of setting new rules for the largest global institutions, various banking groups warn that higher capital requirements -- tantamount to putting limits on leverage -- will reduce credit availability and stunt the economy’s growth.
Getting It Wrong
Here, the bankers are demonstrably wrong. To fully grasp their position, it helps to understand why they find leverage so attractive. Consider two banks, both with $100,000 in assets. The first got the entire $100,000 from its shareholders, giving it a 100 percent capital ratio. The second raised only $1,000 in equity and borrowed the rest, giving it a 1 percent capital ratio. In the first case, a $1,000 profit on the assets will generate a meager 1 percent return on the shareholders’ $100,000 investment. In the second case, the same $1,000 gain will produce a 100 percent return on equity. The second option also has a steep downside: A loss of only $1,000 can wipe out the shareholders.
At a big, systemically important bank, high leverage allows executives to play a heads-I-win-tails-you-lose game with taxpayers. In good times, the leverage makes the bank extremely profitable to shareholders, allowing executives to collect juicy bonuses. In bad times, as the European experience yet again demonstrates, governments have no choice but to step in and bail out the banks, and executives have nothing to fear but a highly remunerative exile. No wonder the average tangible equity as a share of tangible assets -- effectively a simple capital ratio - - at 32 of Europe’s biggest banks is only 4.6 percent, according to data compiled by Bloomberg. Deutsche Bank’s ratio is among the lowest, at 1.9 percent.
Sharply increasing capital levels would make the financial system far more resilient, and would in no way threaten growth. Think about it: If banks don’t get into trouble in bad times, they can keep providing credit just when the economy needs it most. The best available research, led by former Morgan Stanley economist David Miles, suggests that once all the costs and benefits are tallied up, the ideal ratio of equity to assets would be somewhere between 7 percent and 10 percent. That translates, in the bizarre math of bank regulation, into a risk-weighted capital ratio of about 20 percent, or double what the folks in Basel are considering. The researchers also find little risk of erring on the high side. Even risk-weighted capital ratio of 50 percent would be preferable to the status quo.
If Europe’s leaders find the political will for another bailout, they should make sure it’s the last, if only because the dire state of government finances makes it doubtful they can afford any more. Simple, hard-to-circumvent capital rules should be the primary condition of any taxpayer-financed solution to Europe’s financial troubles, and there’s no good reason the required level should be any lower than 20 percent. The only losers would be leverage-obsessed bankers, who might have to go cold turkey and earn a living by finding productive uses for their shareholders’ money. That’s a price society can afford to pay.
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