Sunday, September 18, 2016

Why Are the Big Banks Not Safer?

Larry Summers and Natasha Sarin report:
Since the financial crisis, there have been major changes in the regulation of large financial institutions directed at reducing their risk. Measures of regulatory capital have substantially increased; leverage ratios have been reduced; and stress testing has sought to further assure safety by raising levels of capital and reducing risk taking. Standard financial theories would predict that such changes would lead to substantial declines in financial market measures of risk. For major institutions in the United States and around the world and midsized institutions in the United States, we test this proposition using information on stock price volatility, option-based estimates of future volatility, beta, credit default swaps, earnings-price ratios, and preferred stock yields. To our surprise, we find that financial market information provides little support for the view that major institutions are significantly safer than they were before the crisis and some support for the notion that risks have actually increased. This does not make a case against the regulatory approaches that have been pursued, but does caution against complacency.
The authors highlight the equity betas for Bank of America, Citigroup, Goldman Sachs, JP Morgan, Morgan Stanley, and Wells Fargo which averaged 1.23 in 2015 and averaged only 1.18 before the crisis. If these banks were holding more equity relative to assets, we would expect a decline in these betas. But the authors also note that the average equity to asset ratio fell from 13% to 10%. Let’s break this out into leverage risk (which appears to have increased) and operational risk by estimating the average unlevered beta coefficient which appears to have fallen from around 0.15 before the crisis to 0.12 now. So is the real issue here that we are not requiring the big banks to hold more equity? Yes I know that these banks will protest that higher capital requirements will allegedly increase the cost of capital but this claim is inconsistent with basic finance as Anat R. Admati, Peter M. DeMarzo, Martin F. Hellwig, and Paul Pfleiderer note:
Whereas equity, because it is riskier, has a higher required return than debt, it does not follow that the use of more equity in the funding mix increases the overall funding cost of banks. Using more equity in the mix lowers the riskiness of the equity (and perhaps also of debt or other securities that are used in the mix). Unless securities are mispriced, simply rearranging how risk is borne by different investors does not by itself affect funding costs. These observations constitute some of the most basic insights in corporate finance.

2 comments:

Bruce Wilder said...

It does not seem to me that identifying the first-order effects of requiring greater regulatory equity capital help us much since what we are ultimately interested in are the second-order behaviors.
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Can requiring big banks to account a larger portion of their own financing as equity capital persuade their management to behave better? take fewer or less sociopathic risk?

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