Thursday, March 14, 2013

Underneath the Bankers' New Clothes

Anat Admati and Martin Hellwig are the authors of a new book called The Bankers’ New Clothes. This book has been favorably reviewed by John Cochrane and mostly-favorably reviewed by Matthew Yglesias at Slate, though he has a few qualms about it:
Admati and Hellwig say... we should make [banks] fund a much larger share of investment—20 to 30 percent—with equity... 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... The authors’ partially persuasive reply is that this involves confusing social costs with private costs... 
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.
Admati and Hellwig, along with Peter DeMarzo and Paul Pfleiderer, have in fact studied their claim more deeply than they get into in the book. They have two papers from 2010 and 2012 which provide the technical background for the book. We discussed the 2012 paper, "Debt Overhang and Capital Regulation," in the Berkeley macroeconomics reading group this week. I'll try and walk through it here.

High leverage in the banking sector is frequently implicated as a source of systemic risk. After the financial crisis of 2007-2009, regulators sought to require that a greater share of banks' investments be funded by equity. There have been arguments made (including by bankers) that greater equity requirements would be costly to the economy. Admati et al. (2010) argued that this is not the case: the benefits of increased equity financing would be large, while the costs would be small if not negligible. For instance, one common argument is that increased equity requirements would increase banks’ funding costs because equity requires a higher return than debt. Admati et al. say that "This argument is fallacious, because the required return on equity, which includes a risk premium, must decline when more equity is used." The benefits of more increased equity requirements come from the fact that with more equity funding, banks can absorb more losses without becoming distressed, defaulting, requiring government support, or causing a financial crisis.

In their newer 2012 paper, Admati et al. consider the situation in which leverage is already high, and analyze shareholders’ incentives to change the leverage of a firm that already has large debt overhang. Heavy debt overhang incentivizes shareholders to resist reductions in leverage. The reason is that leverage reductions make the remaining debt safer (reduce the default probability), which benefits existing creditors and anyone providing guarantees to the debt, but doesn't benefit shareholders enough to compensate them for the price they have to pay to buy back debt. Shareholder resistance to leverage reduction can persist even if leverage reduction would increase the total value of the bank. This effect is present even without government subsidies of debt (but such subsidies make it worse.) Debt overhang can create an "addiction" to leverage among shareholders. There is a ratchet effect, where shareholders sometimes want to increase leverage, but would never want to reduce it.

Notice, shareholders are resistant to buying back debt because they are not compensated for the ensuing reduction in default probability, which benefits debt holders rather than shareholders. Something that came up during our group discussion of this paper was the fact that, if debt were already perfectly safe (zero default probability), then reductions in leverage would not reduce the default probability, so this effect would not hold. When default probability is quite low, debt buybacks can only reduce the default probability by a small amount, so shareholder resistance to leverage reduction should be relatively small. So from a policy perspective, it makes more sense for recapitalization to be imposed when times are good (when default probability is low), rather than in the midst of a crisis (when default probability is higher.)

The above results come from a model in which a firm has previously made an investment of amount A in risky assets and has funded itself with debt. The total debt claim is D. Investment returns in the future period are a random multiple of A, xA. The payouts of the firm’s securities in the future period depend on taxes, bankruptcy costs, and government subsidies. The firm defaults if xA<D and pays its debt in full otherwise. The payoffs to the shareholders and the debt holders depend on whether or not xA<D. They first consider whether a buyback of debt (pure recapitalization) can be beneficial to shareholders. They find that "Equity holders are strictly worse off issuing securities to recapitalize the firm by repurchasing any class of outstanding debt." This creates an interesting tension:
When default is costly to the firm, the interests of equity holders can be in conflict with maximization of total firm value. For example, if taxes and subsidies are zero while bankruptcy costs are not, then a recapitalization and buyback of risky debt raises the combined wealth of shareholders and debt holders jointly. Yet, shareholders consider such a move harmful to their interests. Thus, debt overhang can give rise to a situation in which shareholders and debt holders jointly would benefit from a recapitalization and debt buyback, but shareholders would not find it in their interest to recapitalize.
In a somewhat random but interesting anecdote in the middle of the paper, they cite the buyback of Bolivian sovereign debt in 1988 as an example of debt buyback benefiting debt holders. Bolivian debt was trading at 6 cents on the dollar, and there was a notion that the international community should buy this debt and forgive it to provide Bolivia with debt relief.  The market price of Bolivian debt after the buyback was 11 cents on the dollar, and debt holders' wealth collectively increased by over $33 million.

In situations where banks are required to reduce their leverage, there are two main alternatives to pure recapitalization. The alternatives prove equally undesirable to shareholders:
A pure recapitalization involves buying (or paying) back debt using new equity funding, without any change in assets. Alternatively, the ratio of equity to assets can be increased by selling assets and using the proceeds to buy back debt, a process often referred to as “deleveraging.” Finally, the firm may increase the equity to asset ratio by issuing new equity and acquiring new assets. 
We obtain a striking “irrelevance” result: If there is one class of debt outstanding and asset sales or purchases do not, by themselves, generate value, then shareholders are indifferent between asset sales, pure recapitalization and asset expansion. All are equally undesirable from the perspective of shareholders.

If, however, there are multiple asset classes, shareholders prefer asset sales over recapitalization or asset expansion, because all debt is the same to the shareholders, and junior debt is cheaper:
This also may explain why shareholders would choose to engage in asset sales or “deleveraging” (as opposed to recapitalization or asset expansion) if a decrease in leverage is imposed by regulation and there are no covenants protecting senior debt holders. In this case, if the proceeds of a sale of assets are used to buy back junior debt and perhaps make payouts to equity, the senior debt holders lose to the benefit of the shareholders. Shareholders therefore prefer this over a pure recapitalization or asset expansion.
What determines a firm's ex ante decision about debt and equity financing?  By Modigliani and Miller (1958), the capital structure choice is only relevant to the ex ante value of the firm to the extent that it is affected by frictions including taxes, bankruptcy costs, bailout subsidies, and agency costs. If these frictions change, the effect on capital structure is asymmetrical. One interesting policy implication is:
The total value of banks, net of the value of bailout subsidies, can be increased when regulators force banks to recapitalize because, in effect, the regulators can create a commitment technology that allows banks to overcome the debt overhang agency problem that would otherwise prevent beneficial recapitalizations. In other words, assuming there are no bailout subsidies but there are bankruptcy costs (that are incurred by the firm), regulators who force the firm to recapitalize might enhance its ex ante value by allowing it to raise debt at a lower price than it could absent a way to commit to such recapitalizations.
However, as far as I can tell, the model does not help us understand what level of recapitalization is ideal. Does recapitalization monotonically increase the ex ante value of the firm, all the way up to 100 percent equity? The model tells us that higher equity is better, but does not tell us how high is optimal. So I don't know where the 20 to 30 percent recommendation comes from. The model is two-period. It would be hard, but interesting, to think about longer horizons. Another important point is that the result about shareholders resisting recapitalization holds even in a stripped-down model with no taxes, subsidies, or bankruptcy costs. The taxes, subsidies, and bankruptcy costs can exacerbate the result but do not drive it. It would be interesting to see some analysis of how much they are exacerbating the problem.


  1. This is also something that puzzled me for a long time. Ideally, if debt is being subsidized by interest rate tax deductions, the "too big to fail" promise, and FDIC the market would reorganize itself and sell enough equity to finance its operations were these subsidies to be removed.

    However, the tax credits are a relatively small part of the total subsidy, and FDIC is as much for the savers as it is for the bank (though, if banks were sufficiently financed with equity, there's no reason they would default on their creditors in a catastrophic manner).

    With TBTF being so established a phenomenon, there's no way "removing" the subsidy is subgame perfect, especially because there's no legal precedent, but a silent agreement. The government can't credibly threaten markets that it would let them fail. Because they can't do this, banks will be leveraged to hell which, then, forces a bailout, further eroding the chances of a future credible threat against the subsidy.

    Reading Admati over the past several weeks, this question has really puzzled me as well. I'd like the market to decide what's an optimal level of debt versus equity, and 30% or 50% just seems plainly arbitrary.

  2. Ashock, thanks for your comments. One thing about the last part-- if "the market decides" levels of debt versus equity, the market is shareholders, so the level of debt will be higher than optimal, is the point of the paper. There is some optimal level that is not what the market would decide, but I also don't know if it is 30%.

    By the way readers, click on Ashock's name to go to his blog. Interesting topics there.

  3. Right, I suppose that would be the systemic externality associated with debt. Though I, like you, have no idea what that exactly is, and it seems particularly difficult to calculate. I suppose there might be some stress-test like model that could calculate the risk of various events and check that against systemic fallout and base capital requirements on this cost – not sure.

    In any case, Modigliani and Miller show that it doesn't much matter whether a firm wants to finance itself with debt or equity. I suppose they just picked an arbitrarily high value to avoid any chance of systemic failure. That's certainly the conclusion John Cochrane reaches in his review:

    "Ms. Admati and Mr. Hellwig do not offer a detailed regulatory plan. They don't even advocate a precise number for bank capital, beyond a parenthetical suggestion that banks could get to 20% or 30% quickly by cutting dividend payments. (I would go further: Their ideas justify 50% or even 100%: When you swipe your ATM card, you could just sell $50 of bank stock.)"

    And thanks for the tip to my blog !

  4. Yes, bank defenders are often accused of being either crooks or morons on the grounds that they don't know or are ignoring the M-M result. And if memory serves, Admati has produced empirical work that suggests that M-M works pretty well for banks.

    But it seems to me that this style of analysis is disregarding an important social function of banks; they provide not only funding, but also deposit facilities. That is, investors are not indifferent between investing in equity and deposits. If they are obliged to reduce their deposits, the funding will not be entirely made up by new equity investment because some investors are also borrowers and will have the ability to destroy unwanted bank money by extinguishing their own liabilities.

    So even if the cost-of-capital argument is wrong, that does not prove that bank lending will be conserved.

  5. The old hot chestnut toss here
    Between equity and debt
    Is off base

    The real divide is inside vs outside

    As vague as that seems

    The paper patterns are customizable

    A good thought frame

    Powerless Equity holders are just
    Creditors too
    And treated as the opposition by insiders

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