By Edmund L. Andrews
Anat Admati has already become famous – infamous, in some quarters – for her scathing criticism of banking reforms and her outspoken calls for drastically tougher regulations on how much debt financial institutions should be allowed to take on.
In the Bankers’ New Clothes, the book she coauthored with Martin Hellwig of the Max Planck Institute, the professor of finance and economics at Stanford Graduate School of Business argued that reckless bank borrowing or excessive “leverage” was a central cause of the great financial crisis.
Unless government regulators force the banks to increase their reliance on equity — money from their owners and shareholders — Admati and Hellwig warned that banks would continue to pose a threat to taxpayers, to financial stability, and to the economy itself.
In a new paper, Admati, Hellwig, and two Stanford colleagues add a new twist to that argument: Such requirements aren’t just good for the public at large; they are also good for the banks.
The researchers contend that highly indebted borrowers, including virtually all banks, develop an “addiction” to ever-higher borrowing — even when it lowers the total value of the firm to investors. Creditors know that the over-borrowing is dangerous to their interests, but Admati and her coauthors argue equity shareholders have powerful incentives to resist debt reduction and indeed to have a company borrow even more. In the case of banks, where creditors are often protected by government backstops, shareholders are especially likely to trump creditors. The authors call this the “leverage ratchet effect”: an almost inherent tendency of bank debt to rise rather than to fall.
“Not only will shareholders choose not to [take actions to] reduce leverage, they will always prefer to increase leverage,” write the reseachers, who, besides Admati and Hellwig, are two leading experts in the world of corporate finance: Paul Pfleiderer and Peter DeMarzo, both professors of finance at Stanford Graduate School of Business. In 2010, the four wrote a paper that sharply criticized arguments, championed by the banking industry, against raising banks' equity requirements.
The researchers current argument flies in the face of traditional corporate-finance theory, which generally holds that companies select their mix of funding to maximize the total value of the firm. But the researchers say the traditional theories do not adequately recognize how shareholders (or managers acting on their behalf) actually calculate their own self-interest in making those decisions over many years.
The key reason for the “addiction” to borrowing, the authors of the new paper argue, is that debt reduction entails shareholders giving a gift to creditors by taking on more downside risk and making the debt safer at the shareholders’ expense. If a bank wants to buy back its bonds, for example, bondholders will demand more than just the current market price of those bonds. The bondholders will also insist that the buyback price reflect the fact that the remaining debt will have a higher value after the buyback, because the company will be at less risk of defaulting. In other words, bondholders get all the benefits of debt reduction, but shareholders have to foot the cost upfront. To shareholders, that’s a clear disincentive.
The researchers say the “leverage ratchet” is especially relevant for banks. That’s because banks creditors are shielded by government backstops and thus less worried about default than creditors for nonfinancial companies.
For insured depositors, there is deposit insurance. Other creditors, such as the bondholders and counterparties of the largest banks, have reason to believe that the government will bail them out in order to prevent another financial meltdown. That, says Admati, is why it’s so important for regulators to step in forcefully and protect the deposit insurance fund and the broader public.
Overborrowing by banks, says Admati, leads to many problems, including a tendency to underinvest in good lending opportunities and be biased in favor of gambles with more “upside.” For society, the risk is that taxpayers will have to foot the bill if a major financial institution appears poised to fail.
Admati compares the decisions of an over-leveraged bank to those of a homeowner struggling to pay the mortgage. The homeowner may avoid putting any more equity into the house, because he or she would lose it all if he defaults, benefiting the banks that made the mortgage. The homeowner may even choose to borrow more money, perhaps by taking out a second mortgage or a home equity loan, because the risk of that additional debt falls on the creditors.
To be sure, shareholders and creditors understand that overborrowing is dangerous, just as an addict knows that cocaine is self-destructive. To protect themselves, creditors often impose “covenants,” or conditions aimed at limiting a company’s future risk taking and borrowing. In practice, however, the authors say such covenants usually include enough flexibility to let the borrowers run up more debt if they want to. This is what Pfleiderer calls a “commitment” problem: the fact that shareholders are not committed to what they would do or not do at a later time. Once the debt is in place, shareholders will be guided by what is best for them and, within the limits of what they are allowed to do, ignore the impact on creditors.
Regulators in the United States and abroad are pushing banks to increase equity as a share of their total assets, but Admati and her coauthors say the levels are far from sufficient. For bank holding companies in the United States, recent proposals would still allow debt to account for up to 95% of a bank’s assets. Even without regulation, nonfinancial corporations in the United States have, on average, only about 30% debt relative to their assets.
Don’t expect the banking industry to have an epiphany. Five years after the global financial meltdown, banks are still benefiting from easy borrowing, and fighting tougher equity requirements and other regulations tooth and nail.
Would you blow your whistle on kleptocrats? Do you have a news tip, firsthand account of political corruption, or reliable information about a government foul-up? Please send your scoop to Basil Venitis at venitis@gmail.com for publication in http://themostsearched.blogspot.com
CITIGROUP IS READY TO GO BELLY-UP!
Citibank is playing a very dirty game against its customers in Greece. The bank makes its customers sign that their CDs will be automatically be renewed without their approval. Then the bank renews the CDs at the infinitesimal rate of 0.1%!
But getting just one thousandth interest rate on CDs is robbery, pure and simple. Citibank officers at the Paleo Faliro branch declare they have a right to do this scheme, because their customers do not care about interest rates, but the prestige of dealing with the Citibank!
Prestige of dealing with Citibank is a joke, as Citibank has lost its good will. Citigroup suffered huge losses during the global financial crisis of 2008 and was rescued in a massive stimulus package by the U.S. government, but this time around the government cannot rescue it again.
Now Citibank is in big trouble again, playing dirty schemes, such as the infinitesimal 0.1% on CDs. Citigroup is ready to go belly up. A bank cannot survive by robbing its customers.
A securities arbitration panel has ruled that Citigroup must pay $3.1 million to a customer steered to invest in a politician's real estate developments that went broke.
Nasirdin Madhany and his wife, Zeenat Madhany, of Orlando, Florida, filed the case, reporting negligence, fraud, and other Citibank misdeeds involving millions of dollars in stupid real estate investments just to generate commissions for Citibank.
We are thrilled for the Madhanys. They worked very hard for their retirement. It was a just result because a criminal bank must be held responsible when it robs its customers. Citibank has a consistent track record of defrauding its customers, but its days of operation are very limited. It will be a deja vu of Lehman Brothers bankruptcy, with Citibank officers carrying their belongings in cardboard cases!
Sherry Hunt, a former Citi employee, took Citi to court for fraud—and won $31 million. Citibank was buying mortgages from outside lenders with doctored tax forms, phony appraisals and missing signatures, she says. It was Hunt’s job to identify these defects, and she did, in regular reports to her bosses. Executives buried Hunt’s findings before, during, and after the financial crisis, and even into 2012.
The government requires lenders to certify that insured loans meet FHA standards. Citibank flouted those standards. Citibank passed along subpar loans to the FHA, making substantial profits through the sale and securitization of FHA-backed insured mortgages while it wrongfully endorsed mortgages that were not eligible.
Citigroup was fined $75 million for misleading investors over subprime assets. Charges laid by the Securities and Exchange Commission accuse Citigroup of repeatedly making misleading statements and improper disclosures in its quarterly earnings releases during 2007. Citigroup claimed its exposure to high-risk sub-prime mortgages was no more than $13 billion when in fact it was more than $50 billion.
Citigroup agreed to pay $590 million over claims that it deceived its customers by hiding the extent of its dealings in toxic subprime debt.
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