An article from The Baseline Scenario
By Simon Johnson
Posted: 24 Mar 2011 02:15 AM PDT
Four types of people were directly affected by the Federal Reserve’s decision at the end of last week to allow major banks to increase their dividends and to buy back shares. Three of these groups – bankers, bank shareholders, and government officials – were somewhere between happy and delighted. The four group, US taxpayers, should be much more worried (see also this cautionary letter to the Financial Times by top finance academics).
The bankers’ reaction is obvious. They are officially released from the financial hospital ward that was set up for them in 2008. No matter that this was a very comfortable place with few conditions relative to any other bailout in recent US or world history – there were still restrictions on what banks could do and, naturally, bank executives chafed at these constraints.
In particular, banks were required to build up the equity in their business – insolvency is avoided, after all, while there is positive equity in a business. When shareholder equity is exhausted, creditors face losses.
You might think that the people who run banks have an incentive to keep equity at a high level – providing a cushion against future losses and effectively protecting creditors. And banking did operate in this fashion back when government was much smaller and effectively unable to save large financial institutions.
But that was in the nineteenth century – when banks had capital levels in the range of 30-50 percent (and functioned fine at that level). In the twentieth century, the equity in banking has tended to decline relative to debt; this is what it means when people say leverage has gone up.
A thinly capitalized bank is like buying a house with very little money down and a mortgage for 98 percent of the purchase price (and such levels of leverage, up to 50:1, were common in the run-up to 2008). If the house price goes up, you have done very well relative to your initial investment. Of course, if the house price goes down, you are under water faster when there is less equity in the business – and creditors are more likely to face losses (depending on your cash flow and broader incentives to default.)
The Fed’s decision on dividends effectively lets the banks pay out shareholder equity, making the banks more highly leveraged. Bank executives and other key personnel are paid on a “return on equity” basis, so this increases their upside, i.e., what they will make as long as the economy and their sector does well. (Look at Figure 2 on p.15 of the just updated paper by Admati, DeMarzo, Hellwig, and Pfleiderer; their analysis has become central to the debate.)
Up to a point, this also makes bank shareholders happy – their equity (left in the business) will have more leverage and therefore also higher upside. The shareholders should, of course, worry about the bank executives taking on more leverage than is optimal from an owners’ point of view, but it really does not seem that even the more articulate shareholder groups are paying sufficient attention, e.g., to who supervises risk management at the board level.