The Leverage Debate Revisited, aka GREAT MOMENTS IN BANKING HISTORY
This being Christmas (at least for those who didn’t get coal in their stockings), it seemed like a fine time to revisit the leverage debate. We here at The Scrambler thought this was just the moment to return to our occasional series/tongue in cheek hashtag, GREAT MOMENTS IN BANKING HISTORY.
The Baseline Scenario had a great piece a little while back by Anat Admati (she teaches Finance I, among other things at the Stanford GSB). She responds to a long NYTMag article on Jamie Dimon and his assertion that JPMorgan should continue to grow. She also dismantles the larger issue of the cost of capital for the street. It’s riveting. Basically, her argument is that debt financing has made it too cheap for the banks to operate (ie, they don’t fully internalize their costs to society and risk to investors alike due to their heavy reliance on leverage/debt financing). If they moved more towards equity, we’d all be better off (or at least, less likely to suffer another cataclysmic meltdown). Excerpt from the piece below. Click the link here for the full Baseline Scenario. Her article is based on a longer working paper put out last October (the full paper is Scribd below). Print this one out and enjoy with your lunch. If you took a low blow (or some long-dated shares) last week, you could use it to wipe away your tears. But it’s really fascinating. Read it before turning it into Kleenex…
What Jamie Dimon Won’t Tell You: His Big Bank Would Be Dangerously Leveraged
By Anat Admati, Professor of Finance and Economics at Stanford Graduate School of Business. To see her explain these issues in person, watch this Bloomberg interview. This is a long post, about 3,500 words.
The debate is raging about banks and their size, financial regulation, and the international capital standards known as “Basel”. Jamie Dimon of JP Morgan Chase, in his New York Times magazine profile, expresses admiration for the Basel committee and says,
“… they are asking the questions that, in theory, bankers ask of themselves: how much capital do banks need to withstand the inevitable downturn, and what is an acceptable level of risk?”
There is one problem, however. Basel may have asked the right question, but it did not come up with the right answers, mainly because it allows banks to remain dangerously leveraged, setting equity requirements way too low. This fact is not understood because the debate on capital regulation has been mired with a cloud of confusion, and filled with un-substantiated assertions by bankers and others. As a result, the issues appear much more mysterious and complicated than they actually are.
After a massive and incredibly costly financial crisis, we seem to have financial system that is a more consolidated, more powerful, more profitable and, yes, as fragile and dangerous as we had before the crisis. How did this happen and what can we do?
Here are some questions on which the confusion is staggering.
(i) Is “too big” the same as “too big to fail?”
(ii) Do capital requirements force banks to “set capital aside for a rainy day” and not use it to help the economy grow?
(iii) Are banks different than non-banks in that high leverage is essential to banks’ ability to function?
(iv) Would terrible things happen if capital requirements were to increase dramatically?
The first order of business is to clear the fog and focus on the right things. I will try to explain. With the basics in place, answers will begin to emerge, or at least the right questions to ask.
By the way, I answer an emphatic NO to each of the above questions.
