Living wills and financial leverage

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The headline in today’s New York Times, “‘Living Wills’ of 5 Banks Fail to Pass Muster,” might have struck some as another consequence of the Supreme Court’s view that corporations are people. Do companies need living wills like individuals do?

Not quite. The living wills of which the article speaks are bankruptcy plans mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act (usually referred to simply as Dodd-Frank). In particular, large banks that are particularly important to the financial system (often called banks that are “too big to fail” or TBTF) are required to have contingency plans in place so that if the bank gets into trouble it can be liquidated without pulling down the entire financial system.

That five banks’ plans were not approved by regulators does not surprise me.  It’s a skirmish in a wider war between financial intermediaries (banks, insurance companies, etc.) and regulators (the Federal Reserve, the Treasury Department, etc.) over how much financial leverage (i.e. the ratio of borrowed money to shareholder equity) that banks and other regulated institutions will be allowed to carry.  This is the real issue, not the quality of banks’ living wills.

If this is confusing please don’t stop reading. It actually makes sense once you understand a bit of bookkeeping regarding banks, and it’s an important issue to understand as you evaluate political candidates.  Republican candidates, generally, support the system as it is and, in fact, argue that Dodd-Frank should be scaled back.  Democratic candidates, on the other hand, think Dodd-Frank should be tightened but they don’t seem to understand why or how it should be done, just that we should “break up the big banks.”  Neither party’s candidates are dealing with the underlying problem with leverage.

Let’s begin with the balance sheet for a simple bank, one that takes in deposits and makes loans:

 

Assets Liabilities
Reserves Deposits
Short-term loans
Long-term loans Shareholder equity

 

The bank’s assets consist of short-term loans (e.g. auto loans), long-term loans (e.g. home mortgages), and reserves. The bank holds reserves because they need to have cash (or something like cash) available in case depositors want to withdraw their funds.

The bank has two kinds of liabilities: deposits, which people can withdraw whenever they wish, and shareholder equity, which consists of the money the bank’s owners put up themselves.

Now, suppose the bank’s loans start to lose value as some customers default and others refinance their debts (think of a recession when business start to see their sales fall.)  The two sides of the balance sheet must balance, so for a given level of deposits the bank’s shareholders must take a hit and see their equity shrink.  Thus, there is an incentive on the part of the shareholders to make sure that the bank is making high-quality loans that won’t hurt their stake in the institution.

Now, let’s make things a bit more complicated and much more realistic:

 

Assets Liabilities
Reserves Deposits
Short-term loans Short-term debt
Long-term loans Long-term debt
Shareholder equity

I’ve added two items to the liability side.  The bank can now get resources to make loans by borrowing money either short-term or long-term in addition to taking in deposits and selling shares.

We can talk about what happened in 2008 using this framework.  Banks and non-bank financial institutions funded their assets using primarily borrowed money and kept the amount size of shareholder equity as small as possible.  When loans started going bad on the asset side of their balance sheets, financial institutions started defaulting on the loans they had taken out to fund their own lending activity.  Thus, as one bank defaulted (or just as bad, looked like it might default), it’s action contaminated the assets of another bank, causing it to threaten default, and so on through the system.

Notice that shareholders didn’t take the hit. The cost was borne by the system as a whole as one institution put pressure on another.

Dodd-Frank required that TBTF banks have plans in place to deal with this situation; in particular, if a TBTF bank got into a position where it couldn’t remain open it would follow it’s living will and over time close up its loans and pay off its depositors and shareholders.  Dodd-Frank also added a variety of rules and regulations about the types of lending activities financial intermediaries could do on both the asset and liability sides of their balance sheets and, of course, required that institutions report all of this to the government.

Notice, however, that there’s still a big problem here, one that was the focus of a recent conference at the Minneapolis Fed: how do we keep banks from collapsing when their assets go bad and not cause the effects to ripple throughout the system?  After all, the problem ultimately stems from financing their assets using borrowed money rather than using deposits (insured by the federal government) and shareholder equity. Two possible solutions come to mind, at least to economists.

The first is to require banks to raise more shareholder equity.  The most articulate advocate of this solution is Amat Admati of Stanford University.  In her book The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It (co-authored with Martin Hellwig),  Admati argues that allowing banks to finance their operations primarily through borrowed money is inherently dangerous and that by requiring banks to raise more equity will force them to be more careful in their lending activities.

An alternative policy is to think about the effects of one bank on another as an externality. An externality is a cost borne by one person that is created by another; think of second-hand smoke, for example.  In this case, using borrowed money to finance asset purchases creates instability in the financial system, a cost that all institutions (even ones that extremely cautious) must bear.

A classic solution to an externality is to impose a Pigovian tax. The tax increases the cost (at the margin) of, for instance, smoking and thus decreases the amount of smoking people will do and the amount of second-hand smoke they will create.  The same principle applies to financial markets: impose a Pigovian tax, in this case on borrowing by banks to finance their activities.  The tax will encourage banks to borrow less or borrow the same amount but raise additional shareholder equity to cover the cost of the tax.

The problems with living wills clearly need to be repaired.  It’s more important, however, to reduce financial leverage in order to protect the financial system as a whole.  It’s time to get the candidates to discuss this or else we’ll just continue to deal with symptoms instead of the disease.