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The case for equity capital

by Robert Teitelman | Published April 19, 2011 at 1:09 PM

We're deep in the weeds today. The subject is a lengthy and involved academic paper that has become one of the talking points in the great debate over the banks. The paper, "Fallacies, Irrelevant Facts and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive," was written by Stanford Business School's Anat Admati, Peter DeMarzo and Paul Pfleiderer, and Martin Hellwig of Germany's Max Planck Institute for Research on Collective Goods. The paper has been circulating in academia, and has gotten a significant blogospheric push over the last year from MIT economist and blogger Simon Johnson who has held it up as the great refutation of the argument against restraining banks in significant ways. Indeed, earlier this week Johnson declared that an even longer paper by a group from the Institute of International Finance had been "completely debunked by the Admati team." The "Fallacies" paper, as one can tell from the title, is less a work of deep primary research and more a polemic, buttressed by lots of other papers on banking and capital. As a discussion of issues involving equity, debt and leverage, it's fascinating, despite the jargon, poor copyediting and redundancies too often seen in academic papers. ("Fallacies" has been circulating in draft since last August: Can't someone correct the typos and repeated words?) The authors argue that the best solution to the crisis in banking is to force the big banks to raise significantly more equity capital, thus reducing their debt, leverage and systemic risk profile. (Admati has gotten some press by urging the government to restrain the big banks from reinstituting dividends; better to use retained earnings to boost equity.) At the end of the day, the paper attempts to refute the arguments tossed up by regulators, policymakers, bankers and the media about why that's a bad idea: that it's too expensive, will stifle lending and depress returns. They also tackle the same sort of issues with debt; that is they wrestle with the argument that leverage is actually a good thing.

Let it be said: This paper puts forward a provocative thesis and defends it aggressively, almost to excess. Admati et al. attempt to refute every downside of higher equity levels and every imaginable upside to debt. High levels of equity are an unalloyed good. They see no real problems with immediately mandating higher equity levels, even in the short run. They adopt a perspective that looks at banking as primarily a generator of social good. When complexities arise, particularly in the very tangled incentives that make up large banks and in the historical contingencies that have long prevailed, they declare that the public good, as they define it, must prevail, that tax incentives (like the deduction on interest on debt) must be redrawn and subsidies changed. In their world view, both banks and regulation are plastic and easily reshaped. The thornier reality, of course, is that we arrived at this point because of the evolution of a complex political and regulatory landscape that is only partially rational and planned. Banks are not pure public institutions, but complex vehicles beholden to an array of private and public actors, which can't simply be dismissed.

Here's one example. The paper tackles the argument that if regulators demand more capital then returns on equity will fall and share prices will slip -- producing a range of bad outcomes. "This is false," they declare. "A reduction in ROE does not indicate decreased value added. While increased capital requirements can lower the Return on Equity (ROE) in good times, they will raise ROE in bad times, reducing shareholder risk."

Then they start hammering away. ROE, they say, is not a good way of measuring a bank's return in the first place, because it doesn't adjust for scale or risk or for different capital structures. "The focus on ROE has therefore led to much confusion about the effects of capital requirements on shareholder value." Higher equity levels will, they admit, lower ROE in good times, but, in bad times, it will improve the situation, relative to a similar bank with more debt. Should this concern shareholders? "The answer is no. Because the increase in capital provides downside protection that reduces shareholders' risk, shareholders will require a lower expected return to be willing to invest in a better-capitalized bank. The reduction in the required return for equity will offset the reduction in the average ROE, leading to no net change in the value to shareholders (and thus the firm's share price)."

It's good to know they're so confident in the rational response of shareholders who they insist are using the wrong measure of returns. What they're really saying is that shareholders will recognize that banks are safer (which they probably would be with more equity) and they'll reward a kind of equity premium. But is this the way shareholders have reacted with the banks? Elsewhere in the paper, the authors admit that shareholders helped feed bank managers' appetite for risk. What if shareholders decided that they really want banks to max out on the upside because they'll either a) be able to diffuse losses through large portfolio holdings or b) sell their positions as the banks cratered? What if they use ROE because it's easy? Clearly, these self-interested, often speculative shareholders would mightily resist the dilution of issuing more equity and would quietly -- or even noisily -- push for greater leverage to magnify ROE and drive the price. After all, the crisis was preceded by a long stretch of good times when memories of bad times nearly disappeared. How quickly have shareholders forgotten 2008?

Moreover, bankers themselves live in a complex environment that's not recognizable in this paper, which rests upon one economic model after another. The big banks are all public companies. For decades now, shareholders and bankers have come to view a 15% ROE as a standard goal -- unreasonable and risky as that is. Managers are rewarded through ROE, problematic as that measure may be. The money is good; careers are short; and managers constantly hear they are working for shareholders. The natural response when ROE falls below that level would be to seek other means to raise it: to drift further out on the risk curve or to leverage up. Simply saying that that's not a rational response based on academic theory or because it confuses private and public goods doesn't help much here. From within this tightly wound set of real-world incentives that surround bankers, who are no better at predicting the future than academic economists, actions that in the long run may look irrational may appear perfectly fine, even preferable and necessary in the short run.

But even in the longer run, it's debatable whether the optimal scenario the authors posit will occur. Even if shareholders accept the stability argument, they may opt for greater risk and reward, perhaps to their detriment, perhaps not. After all, of all the actors here, they have the most freedom of action. Who are these rational long-term shareholders who will accept lower returns for greater stability?

One of the real problems with banks is that they are assemblages of private actors who are supposed to be generating public goods. We regulate banks publicly; but we expect them to be managed privately. (It's even more confused with shareholders who we insist have a key governance role, and that represent the broad public, but who at other times appear to be dangerously self-interested and just one party among many, including creditors.) We believe we can set up mechanisms of rational incentives that can guide them to beneficial public outcomes. We embrace the notion that we can align private and public goods. But that alignment often appears simplistic and utopian. There is much within this paper that is well worth further thought; I've focused here on just one small section, albeit one that reflects a recurring tendency to spin an argument, not to wrestle with real-life complexities. But while this paper does stir further debate and reconsideration -- overall, raising equity probably is an excellent idea and much of what they say seems correct -- it certainly is not the final word, nor does it completely debunk anything. - Robert Teitelman

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