207
Myerson: Rethinking the Principles of Bank Regulation
were to materialize. At this point the bank-
ers can tell themselves: officially these assets
are safe, and if not, then we will be bankrupt
anyway, so why not borrow more and invest
more to earn even greater profits in the likely
event that all the worriers are wrong? Then,
when the unlikely risk actually does material-
ize, it can bring down a large portion of the
banking system. We have seen such a process
unfolding at least twice in the past decade,
once for AAA-rated mortgage-backed secu-
rities in America, and then again for sover-
eign debt in the euro zone.
Indeed, the current problems of the euro
zone should be understood in the context
of the Basel approach to capital regulation.
At the beginning of the Basel process in the
1970s, the first concern was to make sure that
foreign currency risks were adequately taken
into account in bank regulation (see Goodhart
2011). Also, almost from the beginning of
the Basel process, governments called for
regulatory standards that would encourage
banks to hold their sovereign debt. This bias
to ignore risks of sovereign government debt
in its own currency was not revised when the
sovereign nations in the euro zone lost the
ability to print their own currency. Thus, the
creation of the euro zone converted large
debts between European nations from a risk
category that bank regulators were directed
to particularly scrutinize into a category that
bank regulators were directed to ignore. This
illogic of bank regulations has been funda-
mental to recent crises of the euro zone.
The risk-weighted capital adequacy sys-
tem may have harmed the economy in other
ways. Well-rated marketable securities were
given lower risk weights than loans to indi-
viduals or small businesses. This incentive to
shift banks away from lending to individuals
and small businesses would become particu-
larly acute when bank capital became scarce
in the financial crisis, and the resulting loss
of credit for small businesses would increase
unemployment thereafter.
Moves to bundle and repackage small
loans into marketable securities may have
been substantially motivated by the incentive
to convert these assets into a category with
lower risk weights. But in the financial cri-
sis, enthusiasm for such securitization waned
when it was found to exacerbate moral haz-
ard in lending standards. More broadly, we
should ask how much of recent financial
innovation has been motivated by the goal of
exploiting regulatory loopholes, which effec-
tively encouraged banks to enter a network
of complicated transactions that could make
the allocation of risks harder to trace.
Rules that allow equity requirements to
be based on the banks’ own models for risk
management add another layer of complex-
ity against any hope of public validation of
regulators’ decisions. Furthermore, these
rules can effectively reward banks for using
models that understate their own risks, which
raises the serious danger that senior manag-
ers could deliberately blind themselves to
some portion of the risks that their organiza-
tion is bearing.
In the search for a basic statistical bench-
mark for evaluating when equity is sufficient
to assure that owners have appropriate incen-
tives to avoid risks of failure, it may be help-
ful to consider data about the size of public
losses from failed banks as a fraction of their
deposit liabilities. American banks that failed
during the decades from 1978 to 2007 gen-
erated public losses that averaged about 19
percent of deposits, according to the FDIC’s
historical statistics on banking.
5
One could
argue that, when a bank’s equity as a fraction
of deposit liabilities is less than this average,
the public would statistically expect to lose
more from the bank’s failure than its owners,
and so greater public oversight of the bank’s
investments may then be appropriate.
5
Accessed from http://www2.fdic.gov/hsob/selectrpt.
asp?entrytyp=30 on July 17, 2013.
Journal of Economic Literature, Vol. LII (March 2014)
208
6. Other, More Radical Solutions?
Admati and Hellwig argue persuasively
for requiring banks to have equity worth at
least 20 percent of assets, but a reader should
ask, why stop there? What goes wrong with
the argument for requiring X percent equity
as X percent approaches 100 percent? One
answer is that people have a real demand
for bank debt, because monetary-denomi-
nated deposits serve as the basic medium of
exchange in the economy. Bank accounts are
money that people can use to pay for gro-
ceries, but shares of stock in a bank are not.
People agree to make transactions in dollars
or whatever the accepted legal tender of our
country is, and we need to make these pay-
ments in some liquid asset that has a clear
reliable value in these units. Checking and
debit accounts in reliable banks provide this
vital service for our economy, and so banks’
issues of safe debt can provide real eco-
nomic value.
This basic point of monetary theory raises
some difficulties for Admati and Hellwig’s
argument, however, as the use of bank debt
as a medium of exchange provides a fun-
damental reason why people may be will-
ing to hold bank debt with a lower rate of
interest. It implies that a system of financial
intermediation that financed investments
only by equity might indeed have a higher
cost of credit than one which issued some
form of liquid debt. We should admit that
going to 100 percent equity financing would
be going too far. There is a real transac-
tions demand for bank debt, but the price
that people are willing to pay for it should
decrease as its supply increases. Once the
banks’ fraction of debt financing is large
enough to meet people’s basic demand for a
medium of exchange, then presumably any
further increase in debt financing would not
elicit substantially more savings at any given
overall expected rate of return for the aver-
age investor.
On the other hand, as Admati and Hellwig
have emphasized, there is a real moral-
hazard cost to banks’ issue of debt, as it can
generate incentives for inefficient risk taking
by banks. But marginal moral-hazard costs
of debt should be small when the amount
of equity is large enough to keep the risk of
insolvency negligible. So we may hope to
find a broad range of possible equity require-
ments that would generate enough bank debt
to meet people’s basic transactions demand
for deposits, but would also maintain enough
bank equity to assure that the owners of a
bank will expect to bear virtually all of its
investment risks.
Within this broad range, the Modigliani–
Miller argument could affirm that marginal
changes in the fraction of equity financing
would not significantly affect total costs of
credit. But to make an effective regulatory
system, we need to specify some required
fraction. It seems reasonable to argue that
Admati and Hellwig’s recommended stan-
dards of 20–30 percent equity may be in this
range, while current regulatory standards
may be substantially below it.
A related idea that Admati and Hellwig
might have usefully discussed further is the
narrow-banking proposal that was advo-
cated by Henry Simons, Frank Knight, and
Irving Fisher in the 1930s. Under narrow
banking, as described by Fisher (1935), all
bank accounts that could be used as money
(such as checking accounts and debit
accounts today) would have to be backed
100 percent by reserves of cash or deposits
at the central bank. Fisher argued that this
narrow-banking rule would have prevented
the large fluctuations in the money supply
that he saw as a factor in causing the Great
Depression.
But this argument raises a fundamental
question about how waves of bank failures
could cause macroeconomic downturns.
Would the effect occur through a contraction
of the money supply, or through a disruption
209
Myerson: Rethinking the Principles of Bank Regulation
of credit channels? The recent recession did
not involve any great monetary contraction,
but the shock to the banking system strongly
affected the supply of credit to individuals
and small businesses that depend on bank
loans. Under Fisher’s original narrow-bank-
ing proposal, bank loans would depend on
funds from savings accounts, which would
have remained vulnerable to runs and insta-
bility when banks are weak.
Thus, when we focus on the need to main-
tain stable channels of credit, such narrow-
banking proposals seem less persuasive. The
distribution of credit must depend substan-
tially on financial intermediaries that develop
special expertise in the various sectors of the
economy. The Myers–Majluf adverse infer-
ence provides a fundamental reason why
such firms with special information may, in
the absence of regulatory constraints, regu-
larly choose to finance investments by issu-
ing more debt instead of equity. But if many
of these firms become excessively indebted
and fail, then those who depended on them
for credit will also suffer and real productive
investments that they should have financed
will be lost in the years that it takes to rebuild
a strong financial system. Thus, as Admati
and Hellwig argue (in footnote 28 on p. 271),
narrow banking would not eliminate the
problem that non-deposit-taking financial
institutions might become too important to
fail. The public interest in maintaining credit
channels provides a basic rationale for equity
requirements. Kotlikoff’s (2010) modern
extension of the narrow-banking idea com-
bines it with a requirement of equity financ-
ing for financial intermediaries that make
risky investments.
7. Conclusions
In response to all their arguments against
the increasingly complex provisions for mini-
mizing banks’ capital requirements, Admati
and Hellwig report (p. 182) that they have
never received a coherent answer to the
basic question of why banks should not have
equity levels between 20 and 30 percent
of their total assets. They recommend that
banks should be restricted from paying prof-
its to stockholders until their equity value is
above 20 percent of assets.
This recommendation is simple, but it is
based on their deep command of theory.
The book is long, with many footnotes,
because it takes time to rebut all the bankers’
arguments that society would suffer some
substantial loss of economic growth if such
a fraction of economic investments were
financed by equity instead of debt. A bank
may incur some real cost from equity financ-
ing, but it is primarily due to the fact that an
increase of equity will transfer to the bank’s
owners a larger share of the bank’s risks,
which otherwise with debt financing might
be passed on to creditors or taxpayers. To all
the complex schemes for encouraging banks
to manage risks prudently with less equity,
the appropriate response is that requiring
more equity is itself the single most effec-
tive way to ensure that a bank’s owners have
an incentive to manage its risks prudently.
If more regulatory control of risk is needed,
it can be achieved by basic diversification
guidelines that prevent the bank from lend-
ing too much to a narrow group of favored
borrowers.
I have suggested that it might be better to
define equity requirements, instead, as a frac-
tion of debt liabilities, to put the focus on the
part of the balance sheet that actually makes
equity necessary. A capital requirement of
20 percent of assets would correspond to
25 percent of debt liabilities. Talking about
liabilities instead of assets has the virtue of
moving the discussion as far as possible from
any question of offering lower risk-weights
for some approved assets. Instead, we could
appropriately consider questions about
whether the equity requirement should be
Journal of Economic Literature, Vol. LII (March 2014)
210
on the excess of debt liabilities over cash
reserves, or whether long-term debt should
have a lower equity charge than short-term
debt and deposits. Accounting standards and
regulatory policies that prevent liabilities
from being netted or hidden off the banks’
balance sheets may be essential to effective
regulation.
Bank regulation is obviously a complex
technical matter, and we need to rely on spe-
cialists for the tasks of daily monitoring and
stress tests in a crisis. But if nobody outside
of the elite circles of finance can recognize a
failure of appropriate regulation, then such
failures should be considered inevitable.
We may want our country to have a banking
system that can reliably attract savings from
people all over the world, and that can then
channel those savings into loans that will
help build the homes and businesses of our
communities. Ultimately, in a democratic
nation, the whole system must depend on
informed citizens having some basic under-
standing about what bank regulators are sup-
posed to do.
So financial regulatory reforms are incom-
plete until somebody can explain to the gen-
eral public what the new rules are, at least
well enough so that our officials can be held
publicly accountable for implementing them.
Professional economists can contribute to
such reforms by articulating their essential
principles and laying out their logical argu-
ments as simply as possible. In this regard,
Anat Admati and Martin Hellwig have done
an enormously important service in this
book. But economics professors cannot do
it alone. Political leadership is also needed
to get the public’s attention and communi-
cate the new principles by which the public
should judge its financial institutions, regula-
tors, and politicians.
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