Watch Out! Banks Are Borrowing Way Too Much.

Commentary about business and finance.
March 7 2013 3:16 PM

Banks Borrow Way Too Much

A great new book argues that the finance industry’s love of debt endangers the whole economy.

Goldman Sachs Chairman and Chief Executive Lloyd Blankfein leaves the Manhattan federal court after attending the Rajat Gupta insider-trading trial in New York June 7, 2012.
Should be better control banks' borrowing? Above, Goldman Sachs CEO Lloyd Blankfein in 2012.

Photo by Kena Betancur/Reuters

A company looking to make an investment needs money, and it can get the money in one of two ways. It can finance the investment with debt by borrowing money from a bank or bond markets, or it can use equity by either selling shares of stock or recycling operating profits that could have been used to pay dividends instead.

Debt financing has two advantages over equity financing. One is that interest payments are tax deductible. The other is that the lender gets the same amount of money back no matter how well the investment turns out, so the firm and its owners get to hog a larger share of the upside. The downside to debt, of course, is that if the investment works out poorly, you still have to pay the loan and interest back, and you might go bankrupt. The more debt you have, the bigger your risk of going bust. Since people don’t want to lend money to a company that’s likely to go bust, companies normally try to be moderate in their use of debt. Some companies—Apple, for example—don’t carry any debt at all.

Banks are different. They’re legally required to hold some cash reserves in case depositors want to make withdrawals, but beyond that they largely kick profits out to shareholders as dividends rather than use them to finance investment. Instead, investments are overwhelming financed with debt. They play, in Louis Brandeis’ memorable phrase, with other people’s money. Most simply, they accumulate low-interest short-term loans in the form of bank deposits and recycle the money into higher-rate longer-term loans like mortgages. Modern banks also have more complicated ways of borrowing (money market funds, interbank loans) and spend a fair amount of their time investing in complicated securities trading.  

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Borrowing in order to lend or invest is the core of banking, but while 19th-century banks regularly raised around half of the funds from equity, recently adopted international rules proposing that banks finance no more than 97 percent of their investment with debt are being treated by the industry as the end of the world as they know it. An excellent new book, The Bankers’ New Clothes by Anat Admati of Stanford Business School and Martin Hellwig of the Max Plank Institute, argues that these debt levels rather than the more discussed topics of excessive gambling or “too big to fail” are the real problem with modern finance. And their argument is attracting praise not just from left-wing figures like Simon Johnson but also from conservatives like John Cochrane writing in the Wall Street Journal.

The case, in essence, is that banks are not so much too big to fail as too likely to fail, prompting disastrous financial crises.

Regulatory efforts—like the 2010 Dodd-Frank financial regulation overhaul—thus far have focused on improving supervision of what banks are up to and trying to restrain them from engaging in excessively risky speculation. Proposals to go further typically focus on trying to shrink banks, divide their lines of business, or restrict what kinds of investments they can undertake. Admati and Hellwig say instead we should make them fund a much larger share of investment—20 to 30 percent—with equity. Speculative losses that would bankrupt a financial institution with 3 percent equity would simply push a bank with 20 to 30 percent equity into the danger zone, where it would be banned from paying dividends or engaging in share buybacks until retained profits have gotten it out of danger. A bank that phenomenally screwed up and fell below 20 percent would face sterner discipline while still having a nonzero equity cushion.

Conventional wisdom both in the industry and among the regulatory establishment is that this would be economy-killing madness leading to huge increases in borrowing costs. Brookings Institution fellow Douglas Elliott, in one of the milder critiques, says borrowing costs would rise by about 2 percentage points. Today’s 4 percent mortgage, in other words, would cost 6 percent in an Admati-Hellwig world.

The authors’ partially persuasive reply is that this involves confusing social costs with private costs. Bankers like to say that debt is cheap and equity expensive, but if debt is so cheap why don’t other kinds of firms rely on it to the extent that financiers do? The reason is that for normal companies, debt stops being cheap once they’ve already borrowed a lot. Heavy debt makes bankruptcy more likely, so investors demand higher interest rates. Banks escape this because their creditors have explicit (think Federal Deposit Insurance Corporation) and implicit (think AIG or Fannie Mae and Freddie Mac) guarantees and because past experience with liquidating financial firms in bankruptcy (think Lehman Brothers) have been very unhappy. Debt’s cheap, in other words, because it’s subsidized—meaning heavily indebted banks represent a transfer of wealth from taxpayers to the financial industry.

Less convincing is the authors’ claim that imposing stricter capital regulation would have no costs. They analogize their proposal to rules preventing firms from engaging in excessive pollution but fail to explore the analogy deeply enough. Just because such rules make society better off overall doesn’t change the fact that specific people—not just fat cats but ordinary workers and even whole communities—can suffer huge economic losses as a result of stricter environmental rules. In particular, while letting factories pollute willy-nilly is a bad idea, it does get you cheaper manufactured goods.

By the same token, some of the benefit of society’s bank subsidies accrues to customers. Rolling back the subsidies with dramatically tougher capital requirements really would make some kinds of loans scarcer.

On the other hand, the idea that this would be an economy-killer lacks any real basis. The Federal Reserve sets economy-wide interest rates through monetary policy and could offset the overall macroeconomic impact of tighter lending standards. The difference is that some kinds of borrowing—by consumers and small businesses from banks—would get more expensive, while it would get cheaper for large firms and governments to borrow in bond markets. That’s not a free lunch, and in the short-term at least it might make some people pretty unhappy. But it’s not an unattractive vision either. The aughts’ experiment in substituting cheap consumer credit for rising incomes didn’t have a happy outcome, and while nobody likes to stand up for big business, the fact is that large-firm investment activity is an important driver of long-term productivity. Forcing banks to borrow less, in other words, wouldn’t just mean a safer financial sector: It’d give a different shape to the real economy. Yet far from undermining the case for stricter capital requirements, this arguably strengthens it. The provision of implicit subsidies to bank debt distorts the overall economy, and tough rules to limit borrowing are an appealing way to get back on track. 

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