What you, and the regulators, should know about bank capital and market discipline

A decade on from the financial crisis and the capital markets continues to be in perilous shape, with international finance still dominated by a dozen or so financial behemoths who can all be included in the infamous too-big-to-fail category. To a free market economist, it is hardly surprising that the banking sector is still massively leveraged, and contagion beyond the sector comes about so easily. Since the 2008 crisis, regulators have tried to treat the symptoms and not the disease ravaging bank balance sheets.

Banking is not special; the same incentives operate here as in any other industry. Equity investors hold an instrument that is comparable to a call option: unlimited upside, limited downside (the stock can only go to zero). Any 1st year finance student knows that a way of increasing the value of a call option is to increase volatility. For the same equity, a larger balance sheet means a more volatile stock price. So, the banks leverage up, like any other corporate would. What normally prevents a company from continuously increasing leverage is the increasing price the lender will ask for funds as risk increases. Lenders tend to get nervous if the borrower leverages up and increases volatility – they have no upside from increased volatility, as the return on their investment is the agreed interest rate, no more, but substantial downside as their capital investment is at risk if the borrower defaults. So, they demand increasingly higher credit spreads as leverage increases. Eventually the lender stops leveraging up, when the rising cost of funds surpasses the falling marginal return on additional capital investment. Or so it should be. Not so in the financial sector. We all now know that the large banks don’t fail, they are ‘systemically important’ and will be bailed out. And investors have known this for a long time – Too Big To Fail wasn’t invented in 2008. Banks continue to borrow at low spreads, even when leverage goes through the roof. There’s a fundamental lack of disciplining market forces.

This is reinforced with the current zero interest rate policy, as the cost of short term borrowing is virtually zero, meaning any investment project with a positive expected return makes sense (banks tend to borrow short term and lend out long term, so just by virtue of a steep yield curve, banks can in principle find an unending supply of profitable investments as long as their credit spreads stay low).

To be fair to regulators, they do recognise that it would be beneficial for debt investors to be incentivised to ‘activism’. Unfortunately, they can’t think of anything better than Contingent Capital(“CoCo’s”, a form of debt that suffers losses in times of financial distress and can be converted to equity) to achieve it. This is the way a statist regulator thinks he can ‘buttress market discipline’: force banks to issue complicated instruments like CoCo’s to at least introduce a modicum of market discipline.

Much more is needed. Removing any and all state support from the banking sector (including depositor guarantees) would lead to a drastic reduction in the size of bank balance sheets and more, but smaller banks. Banks would fail if they made wrong lending decisions, exactly like other businesses fail if they invest foolishly. Depositors would have to vet their bank like they vet any other major decision, currently not guaranteed by the state (a car or a house, for example). To spread the risk, they could have multiple bank accounts. A bank with a risky lending portfolio or high leverage would have to pay higher interests to attract investors and depositors. The market would work as intended.

Out in the real world, regulators can observe what would happen if they decided to collectively resign. At various points since the financial crisis, bank credit spreads have been more volatile, responding to distress elsewhere in the market and reflecting fear that bond holders might this time actually suffer losses. The Cyprus experience, when Cypriot banks went bankrupt and were allowed to default on their debt, established precedence for bail-in of bond holders. They could face total wipe-out before tax payers are on the hook.

Unfortunately, the fact that Cypriot banks were allowed to fail does not mean that the financial behemoths of the world run the same risk. Too-big-to-fail has not been abolished. What we are seeing now is that little bit of market discipline at work. Regulators should pay attention and imagine what the world would look like if market forces were truly allowed to play out.


This article was originally posted in October 2016.

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