Why Bankers Hate Equity

Basel III, landmark new rules drawn up Sept. 12 by central bankers and regulators seeking to prevent a repeat of the recent financial crisis, will require banks to lift their reserves substantially

Photograph by Roslan Rahman/AFP/Getty Images

Listen to bankers talk about the new Basel III rules requiring them to hold an equity buffer of 4.5 percent of risk-weighted assets and you’ll hear that it’s essentially the end of the world. Meeting those standards would require curtailment of lending that will strangle the global economy, at just a time when we need looser credit conditions, not tighter ones. Nonsense, says Clive Crook in an excellent column, “equity is just another source of funds” and there’s no reason a bank that thinks it has profitable lending opportunities can’t raise the funds it needs to exploit them by selling equity rather than attracting new deposits. The issue, as Crook points out, is simply that raising the funds as equity is worse for the pay of bank managers:

If banks sell more shares, it’s true that the return on equity will fall. If managers’ pay is tied to return on equity (as it often is), they will be worse off. Shareholders, on the other hand, shouldn’t mind, because the risk of their investment is reduced in proportion. Taxpayers, of course, would be better off – less likely to be stuck at some point with the cost of bailing out the bank.

This is a key point for reasons beyond Basel III. Throughout the current crisis, immense harm has been done to public policy by confusion between the interests of banks and the interests of high-level bank managers. A modern economy needs healthy banks to function. This is different from saying that a modern economy needs the people who happen to be managing banks at any given time to prosper. The debt/equity distinction is very important in this regard not just in terms of Basel III but also in terms of “bailouts.” One way the government can prop up an insolvent bank is to take a bunch of money and use it to buy shares in the bank. Another way the government can prop up an insolvent bank is to declare that it’s a mere liquidity problem and then offer the bank loans at sub-market rates. These mechanisms both give money “to the banks.” But behind door number two, the government officials can claim that they’ve been tougher “on the banks” since it was only a loan and in the end the taxpayer pays no price. In reality, however, what the government officials are doing is being softer on the bank managers. Recapitalizing a bank through cheap loans and regulatory forebearance increases the return on equity, whereas recapitalizing a bank through an equity injection reduces it.

Crook’s bottom line is that Basel III isn’t nearly strict enough and recommends “a ratio of 20 percent of risk-weighted assets, more than double what is currently proposed.” I’m all for that, but would add that we need a return to sound principles on handling a panic. You should “lend freely” to prevent liquidity problems “but at a penalty rate” to prevent covert recapitalization. If systemically significant institutions need capital and can’t raise it from the private sector, the government should become a co-owner.