Towards a Safer World of Banking

T.T. Ram Mohan

• Publisher: Business Expert Press
• Year: 2017
• Print ISBN: 9781631574375
• eBook ISBN: 9781631574382
• Topic: Economics
• Subtopic: Banks & Banking
• Index: Economics

The book contends that, while several factors can be blamed for the financial crisis of 2007, a failure of regulation was the most important one. The changes to bank regulation that have happened since are not good enough to make the banking system a great deal safer than before We need to look at radical, out-of-the-box solutions if another major financial upheaval is to be prevented.

CHAPTER 1

Banking Crises

Why Banks Are Fragile

Banks are fragile. They are prone to failure. We know that very well, don’t we? Some of the largest banks failed or were on the verge of failure during the financial crisis of 2007. They included some of the best known and respected names in the financial world: Royal Bank of Scotland, Citigroup, Bank of America, and investment banks such as Bear Stearns and Lehman Brothers. Governments had to spend billions of dollars to rescue banks even while letting many fail.

Banks are connected with each other in ways that we shall soon make clear. So the failure of one or more large banks can cause several other banks to fail, leading to a crisis for the banking sector as a whole. And when the banking sector as a whole is in crisis, it tends to drag down the economy. Again, we have come to understand very well the havoc that a banking crisis can create in an economy—the global economy is still struggling to return to the growth path it was on before the crisis.

What is it that makes banks so fragile? Well, the key to bank fragility is the high level of debt—more precisely, the ratio of debt to equity (or “leverage”)—at which banks operate. For a manufacturing company, a debt-to-equity ratio of more than, say, 1:1 would be considered high. In shipping, the ratio tends to be higher, say, 4:1. It can be even higher in infrastructure sectors, such as roads and ports. In banking, we have been willing to tolerate a debt-to-equity ratio of 30:1 and even higher.

Students of finance would know that as the ratio of debt to equity rises, the probability of failure (or “bankruptcy”) rises. As debt rises, so does the interest that the firm has to service. More and more of the firm’s income goes toward servicing the interest burden. As a result, even a small drop in income could mean an inability to service debt. The extraordinary leverage at which banks operate is thus the source of fragility in banking.

Why banks are allowed to be so fragile is a matter of debate. One argument made for the high leverage allowed to banks is that debt is less costly than equity. Debt also carries tax benefits whereas equity does not. The post-tax cost of debt is, therefore, considerably lower than that of equity. When banks are allowed a high debt-to-equity ratio—the argument goes—the total cost of capital for banks becomes lower than it would be otherwise.

The cost of capital of a bank has implications for the rate at which it lends. If we view the lending rate as the sum of three elements—the cost of capital, the cost of operations, and a profit margin—then it should be obvious that keeping the cost of capital low translates into a lower lending rate for borrowers. Investment in an economy is inversely proportional to the lending rate. The lower the lending rate, the greater the investment in the economy and the higher the growth rate.

In short, allowing banks to carry a high level of debt benefits the economy by translating into a higher growth rate. We shall examine this argument critically in Chapter 3. For now, let us stay with the argument and focus on the outcome of permitting extremely high levels of leverage of banking. Let us see what happens when banks operate at a high leverage.

Consider a bank, Bank A, with a balance sheet of a bank as shown as follows:

Liabilities		Assets
Equity	$10	Loans	$100
Deposits	$90
	$100		$100

The bank mentioned previously has a leverage of 90/10 or 9:1, which is very modest by the standards of today’s banks. Suppose the bank’s loans were to fall in value by just 10 percent to $90. What would happen? The equity of the bank would be wiped out, that is, the bank would go bankrupt. Thus, in a portfolio of loans, only a small proportion of loans—in this case 10 percent—needs to go bad for the bank to go bust. This is the outcome of high leverage.

Let’s take this a little further. It’s not necessary for the value of loans to fall by 10 percent for the bank to fail. Suppose the value of loans falls by 5 percent, so that the value of assets is now $95. If word of this got around, depositors would conclude that the bank was close to failure. They would then start queuing up to take back their money.

To meet the demands of depositors, the bank would have to quickly sell some of its loans to meet the demands of depositors. Here’s another problem with banks: Deposits are liquid (the bank has to allow customers to withdraw their deposits whenever they like) but loans are illiquid, that is, they can’t be turned into cash easily.

Since the bank is desperate to raise resources to meet the claims of depositors, it would have to resort to a distress sale of loans, that is, loans would have to be sold at steep discounts to the face value. This could easily translate into a further loss to the bank of $5. Thus, a drop in value of just 5 percent could push the bank into bankruptcy if it triggered panic amongst depositors.

Depositors could panic even if they heard bad news about other banks. They might conclude that it was only a matter of time before their own bank was affected. So even bad news about the banking sector could lead to a run on banks. This is what makes banks especially prone to failure.

But the problem does not end with banks that fail. Thousands of nonbanking firms fail every year without our even noticing these. Bank failure is very different in that it has serious repercussions for the economy at large. This is what distinguishes the failure of a bank from that of a nonbanking firm.

Bank Failure Has Negative Externalities

What do we do with a typical firm whose equity is wiped out? We declare it bankrupt. The shareholders get wiped out. Under the bankruptcy process, the assets pass into the hands of creditors. An administrator is appointed who proceeds to liquidate the assets of the firm and distribute the proceeds amongst the shareholders.

We have seen that a bank can get wiped out even with a small decline in the value of its loans. Suppose we were to apply the usual bankruptcy procedure to a failed bank. What would be the outcome?

Well, in the example given earlier, Bank A would recall the $90 in good loans from borrowers and give it back to depositors. Let us suppose that the bank is able to recover the loans in full (we shall see in the following that this may not happen). The depositors would then go to another bank, Bank B, and place this amount with it. Bank B would then look for borrowers to whom it can lend it out.

Let us say it would like to give loans worth $90 to the firms from which Bank A had taken them back. This is not something that can happen instantaneously. Bank B would have to evaluate the borrowers, build relationships, and gradually raise its exposure to the erstwhile borrowers back to $ 90. The whole process—from the liquidation of Bank A to the reconstruction of loans to the borrowers of Bank A by Bank B—would be enormously time-consuming. It would take, say, a couple of years.

And what would we have achieved? In order to uphold the principle of bankruptcy, we would have deprived firms of vital credit of $90 for two years, thus creating disruptions in the economy. While the liquidation process is being completed, the operations of Bank A’s borrowers would be adversely impacted. They may not be able to fully service their loans as a result. Some borrowers would not think it worthwhile to repay their loans in full to a bank that has gone bankrupt—why do so when there is nothing more to be derived from the relationship? Hence, the value of Bank A’s assets could fall well below $90 and the depositors might end up receiving a lower amount than what they had put into the bank.

The problem is not confined to the Bank A’s investors, borrowers, and depositors. Banks are connected to each other in various ways. They are connected through the payments system. One bank’s loan could be another bank’s deposit. The failure of one bank could thus put other banks at risk. This is called “contagion.” Contagion could jeopardize the entire banking system. When one bank fails, it could undermine depositor confidence in other banks and trigger a general run on banks. Contagion thus tends to magnify the externalities associated with bank failure.

This illustrates an important problem with bank failure. It carries large “externalities,” that is, it imposes social costs that are greater than the private costs to the bank’s investors. It is not just the shareholders and creditors of the failed bank who bear costs; the broader economy is adversely impacted.

There are externalities with the failures of other firms as well. When a car maker fails, it impacts a range of vendors and dealers. But the externalities that go with bank failure are significantly greater. That is why it is difficult for governments to allow a bank—and especially a large bank—to fail. It should be clear now why governments spent enormous amounts during the financial crisis in trying to rescue banks that had failed or were on the verge of failure. Not doing so would have i...

Table of contents

• Cover
• Title
• Copyright
• Foreword
• Acknowledgments
• List of Abbreviations
• Chapter 1. Banking Crises
• Chapter 2. Causes of the Subprime Crisis
• Chapter 3. Regulatory Reform Since the Crisis
• Chapter 4. Addressing the Too-Big-To-Fail Problem
• Chapter 5. A Safer World of Banking: Out of the Box Proposals
• Notes
• References
• Index
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