Misconceptions about bank equity February 2, 2013 at 6:51 am

Izabella Kaminska, good though she usually is, is mistaken. She says on FT Alphaville:

Bank resolution is fundamentally about transferring bank responsibility (and risk) away from the public sector and back to the private sector. It’s about making the banks responsible for themselves again by weaning them off state-aid.

Even though government loans have on the surface been repaid, the central bank put and the understanding that these institutions are now too big to fail, implicitly continues to provide an equity backstop. The equity risk has thus not yet really been transferred to the private sector at all.

(Emphasis from the original.) In resolution, bank equity is usually written off. That hurts private sector investors. Resolution regimes even allow debt to be written down. Again, this is a risk private sector investors in banks bear. So Izzy’s claim in the final sentence does not hold water.

Next, QE and the lack of a bid for bank equity:

while QE has been successful at encouraging the market to take risk in some quarters of the market, it’s failed dismally at persuading investors that the bank model is ever going to be a good bet — even in a less risky environment.

Yes, because bank investors are terrified that supervisors might listen to someone like Admati (an academic who inspired Izzy’s article) and demand that banks issue a lot more equity. If they do, current investors are diluted. The risk of that, combined with bank opacity, means that there are few buyers for bank equity. Most large banks are perfectly profitable, so Izzy’s claim that

banks are borrowing short and lending or investing long … in a way that continuously destroys capital.

Is simply wrong – they are having ROE issues, but that’s different. From errors of fact, it is hardly a surprise that errors of diagnosis result. For instance further down the post we find

the only solution lies either in fully equitising banking or turning to a borrowing long, lending short alternative

Banking isn’t broken, and there is still plenty of money (and bearable amounts of risk) to be made in taking deposits and making loans. Banks borrow short and invest long because that is what clients want them to do. And yes, because the curve usually points up and so you can make money doing it. Upward pointing curves will come back in due course. What’s broken is investor’s trust in bank regulation and bank disclosures – and the solution to that isn’t using a theorem that doesn’t hold in practice (Miller Modigliani) to justify a radical, unproven change in regulation like requiring that banks be 100% equity funded at a time when the monetary transmission mechanism is broken. I would even suggest that there is far more systemic risk in taking Admati’s ideas seriously than there is in current arrangements.

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