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April 8, 2013

The too-big-to-fail megabanks’ double standard of “do as I say, not as I do”


The global too-big-to-fail megabanks always protect themselves, but never want to protect others from their recklessness which delivers them unimaginably large bonuses and riches.  For example, few people, if any, can get a home loan from a bank unless they put 20% down, i.e., banks don’t allow people to borrow more than 80% of the value of the home they want to buy.  That’s the borrower’s equity and banks require it to protect themselves.  If the borrower can’t replay the loan and the bank has to foreclose, then the bank can sell the house with little or no loss to the bank. 

That’s sensible and prudent risk-management for the bank, which is protecting itself by requiring the 20% equity cushion to absorb any losses and make sure the bank doesn’t lose any money. 

But, the megabanks reject being held to the same standards when they borrow money.  In fact, the massive global too-big-to-fail mega banks run their business with as little equity as possible, often less than 5%, i.e., they borrow 95% or more (called “leverage”).  That means, if they get in trouble, a loss of just 5% will result in failure and bankruptcy, unless they are saved by the American taxpayers.  That is what happened in 2008-09 when their high risk reckless and irresponsible lending and trading caused the worst financial collapse since the Great Crash of 1929 and caused the worst economy since the Great Depression, which is still causing economic wreckage across the country.

A key reason the government and taxpayers had to bail out the biggest banks in 2008-09 is because they didn’t have enough equity to absorb the massive losses they caused to themselves and other megabanks. 

Many think this is wrong and a key financial reform is to get these global megabanks to have more equity to reduce the threat that they pose to our financial system, the real economy and to taxpayers.  Those big banks are, of course, fighting day and night to prevent that because, perversely, the less equity they have the bigger their bonuses.  That’s what the fight is all about.

Democratic Senator Brown and Republican David Vitter have been fighting for a while now to get the megabanks to have more equity.   Recent reports state that they are  now drafting a bill that would require banks to fund at least 10 percent of their assets with equity, and that megabanks with $400 billion or more in assets have at least 15 percent equity funding  — this is only 6 US bank holding companies. 

Such  equity requirements are perfectly sensible and, indeed, a little conservative.  This is particularly true if you consider what banks demand of the customers for equity or if you consider the substantial losses banks have recently experienced.  Banks fail because they experience losses that they cannot pay for from their own resources — that is, from assets they financed with equity.  During 1986-2008, the median loss rate at a failed bank was 19 percent, and in 2008 the loss rate peaked at 28 percent.  Losses at large failed holding companies were also huge.  For example, after National City was merged into PNC to prevent it from failing, PNC wrote off more than $12 billion, 9 percent of National City’s last reported tangible assets.  Substantially beefed-up equity requirements are required if banks are to be self-insured against losses on the scale we have observed.

Moreover, meaningful amounts of equity will also reduce the likelihood of runs by the short-term creditors who are important funders of large banks.  At its peak, Federal Reserve emergency lending was over $1.2 trillion, and it was supplemented by hundreds of billions in FDIC debt guarantees and TARP loans. Those loans and guarantees were necessary because banks and large broker dealers were bleeding short-term funding and had little to no equity.  They would have taken large losses if they had been forced to sell assets at fire sale prices due to the financial crisis.  They were saved from this only when the federal government became their creditor.  We cannot allow this in the future and requiring the banks to have more equity is one very important way to do it.

Critics of the as-yet-unreleased bill have focused their criticism on the equity requirements, asserting that they would somehow restrict credit, i.e., if banks are required to have more equity, they would lend less and the economy would suffer.  Great argument if you’re a global too-big-to-fail megabank trying to protect your CEO’s bonus, but there is little evidence to support this claim.  Bank borrowing has varied widely over time, but there is no apparent correlation between changes in bank borrowing or equity and the price they charge their borrowers.

Brown and Vitter are clearly on to something and banks, especially massive global too-big-to-fail megabanks must be required to have more equity  These points have also been nicely and fully illustrated in a recent book: “The Bankers’ New Clothes: What’s Wrong with Banking and What to do About It” by Anat Admati and Martin Hellwig.



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