In the last post I argued, how increasing the amount of regulation necessarily increases complexity. Furthermore, I argued that basing regulatory capital requirements on banks’ own assessments, increases complexity even further as it introduces a high dose of subjectivity (paired with conflicts of interest) resulting ultimately in arbitrary and hard to predict regulatory action.
In this post I will touch the issue of moral hazard in the current banking/regulatory framework.
No progress in the last five years addressing the moral hazard issue
The BofA story is symptomatic for the banking industry: as soon as there seems to be an opportunity to increase leverage (i.e. to reduce capital) bank management will take it. It seems nothing has changed, despite every politician on the globe preaching how we need a robust banking system. In the case of BofA passing a regulatory stress test, led management to conclude that it had USD 6.5 billion of “spare” capital. Later it turned out that the stress test capital calculations were wrong and it had to revise its decision – much to the amusement of commentators such as Matt Levine.
Now one might say it is the duty of management to maximize shareholder value and if management thinks that levering up the balance sheet is the right way to go, let it be. Generally speaking, there is nothing wrong with this view. It just ignores that banks are not entirely comparable to private companies even though bank managers love to stress they are businessmen as everyone else. The reason of course is that a substantial part of a bank’s earning power stems from government granted privileges:
- Deposit insurance, i.e. lowering the cost of leverage thereby providing an incentive to increase it
- Access to central bank facilities, further decreasing the cost of leverage by lowering the need for a liquidity reserve to meet outflows
Historically banks have been granted these privileges not to enhance stability, as you are thought in your mainstream-macro course, but to finance government expenditures, e.g. wars or social programmes. For example, it is widely acknowledged nowadays among historians that WWI could not have lasted that long, if the necessary funds would have had to be raised by taxation (thereby greatly reducing its popularity with the masses) instead of printing the amounts necessary (thereby deferring the cost of war) – an action which ultimately led to the abandonment of the gold standard.
Given that a large part of the economic value of a bank is due to government support, it can be argued (even if you are free market like me) that, under our current arrangements, tax-payers are legitimate stakeholders in every bank. The problem with this state of affairs, however, is that it is inherently conflicting as the interests of tax-payers and shareholders/management are diametrically opposed. So far, so good and usually this fact is widely recognized, the common view being that it is the governments (regulator’s) job to moderate this conflict with the government acting as an agent of the tax-payer. The problem is, and this is usually NOT recognized: the government is not a suitable agent as it has a symbiotic relationship with the banks! How? Simple: banks like larger leverage/balance sheets, government like more credit financing, i.e. larger balance sheets. Expanding credit and voter confidence usually go hand in hand. The interest of a government with budget deficits (are there any others?) and banks are aligned, which explains why bankers are probably the most successful lobby-group (farmers a close second), be it in Brussels or in Washington. People who are furious that bankers seem to get away with everything although they are, in the general public’s eyes, the “culprit” for the last crisis, do not understand this last point enough, in my view!
To sum it up: we live in a world where banks are expected to maximise shareholder value, just as if they were your average car producer. Since they do not pay the full cost of leverage, increasing leverage is shareholder maximizing (technically speaking: the value of the equity option increases due to higher volatility as the increased leverage doesn’t increase the cost (option strike) commensurately), which is why managers/bankers, as a rule, will usually take every chance at increasing leverage, thereby undermining the stability of the system. The regulator usually has a symbiotic relationship with the very banks it is supposed to control, which is why regulation fails more often than not. Viewed this, not much has changed in the past five years as the main rules/incentives in the system are still same.
In the next post I will touch the issue of bank accounting rules.