What Occupy got wrong
It’s taken an Israeli and a German academic to do it, but finally someone is writing in plain English about banking: what’s wrong with it and what to do about it. And their message is stark – because of the way in which they fund their activities (by borrowing huge amounts of money), banks still present huge risks to the global economy and to taxpayers. What’s worse, argue Professors Anat Admati and Martin Hellwig in The Bankers’ New Clothes, is that legislators and policymakers are not taking the right actions to fix it.
Last night, Admati was guest of honour at a Demos Finance ‘in conversation’ event – a new series of debates challenging some of the most entrenched myths about finance and business. Admati spoke compellingly, energetically, and – most importantly – clearly about the problems still inherent in global banking. The debate since the financial crisis, she said, had largely focused on what banks do – for example, taking risky bets on complex and shadowy products. In fact, the focus ought to be on how banks fund these activities.
Put simply: ‘banks borrow money too.’ A lot of it. Most corporations fund themselves with a mixture of equity (money from shareholders) and debt (loans from creditors). But no companies borrow like banks. In Europe, for example, equity makes up at least a third of the total assets of most healthy corporations. Banks typically have less than 10 percent equity and often less than five percent.
If you wonder why that’s a problem, think about the 95 percent mortgages that went out of the window once the financial crisis erupted: funding your house by borrowing a huge amount looks good when and if you can afford the repayments, but it suddenly and quickly tips you into the realms of repossession if the economic tide turns.
Borrowing is attractive to banks in a way that it is not to other firms largely because of the implicit and explicit subsidies that the industry receives from government. Why would you invest more of your own money if you knew that in the worst-case scenario, someone else was going to bail you out? Making borrowing cheaper through tax breaks that favour debt over equity also skews the picture.
Admati’s message is simple: governments and regulators need to force banks to change their funding mix so they rely less on borrowing. And she is scathing about the way any conversation about asking banks to ‘hold more capital’ is portrayed. ‘Capital is used as synonymous with cash reserves,’ she says. ‘It is not.’
Bankers, she argues, like to suggest that by increasing the amount of equity in their business, they are being required to ‘hold money for a rainy day’ that cannot then be spent on much-needed loans for small businesses, to give one example. This is not the case. And she argues journalists, politicians, and even regulators are also to blame for allowing bankers to peddle this myth.
As a business, the money you have as assets – whether they are loans or equity, is yours to choose how to spend. Yet we have allowed banks to persuade us that they can only use the money they have borrowed, not the money that shareholders put in, or the money they accrue if they keep back some of their profits instead of paying it out in dividends to shareholders or huge bonuses to staff.
The recipe for change is disarmingly simple – banks should be required to increase the equity in their businesses (Admati and Hellwig suggest 20 to 30 per cent of total assets). Since banks will not do this unilaterally, governments and regulators should take the lead. The Occupy movement, Admati argues, were in a sense targeting the wrong people and should have focused instead on camping outside the Bank of England, Federal Reserve, Congress and Parliament.
There are issues with how to achieve the changes Admati and Hellwig seek. David Benson, Vice Chairman of Risk and Regulatory Affairs at banking group Nomura, and the host of Demos Finance’s event, pointed out that increasing equity to the levels suggested would leave investors in the UK holding a significant amount of bank shares in their portfolio. And the fact that the Professors concede there is no precise ‘one size fits all’ figure for the levels of equity to debt – other than that banks have to have a whole lot more equity – opens them up to precisely the kind of regulatory wrangling that has delayed bank reform across the globe.
But having more people speak out loudly and clearly about the continued weaknesses in a system that has cost all of us dearly is something to be championed. It’s what Demos Finance is all about.