Supporters of Capitalism Should Read This.

Andrew Smithers
The Motley Fool, 21st April 2010

Bankers have brought capitalism into disrepute. To their traditional enemies on the Left they have added those who favour free markets. Despite the remarkable achievement of uniting such a broad spectrum of political opponents, bankers clearly expect to avoid retribution for their misdeeds. Supporters of capitalism, who want its benefits preserved, call for large increases in banks’ equity capital. US banks have responded by buying back their equity.* The Left denounce the outrageous pay levels and bankers respond by awarding themselves huge additional bonuses.

These actions suggest that bankers, as a group, are not unduly sensitive people. But it is nonetheless incredible that they do not realise that large increases in their equity will be part of the new regulations. Their motive in buying back part of their already inadequate equity calls therefore for examination.

Tax-payers guarantee banks’ debts. No industry in this happy position needs any equity unless it is required by law. The guarantee is therefore a subsidy, because capital is a cost and equity capital is its most expensive form. Supporters of capitalism favour unrestricted competition and abhor subsidies. They are therefore natural opponents of the fact that tax-payers subsidise banks. There are two possible solutions, one is to end the guarantee and the other is to increase the amount of equity required by regulation until the increased cost offsets the subsidy. Only the second approach is a practical possibility.

Faced with the question of how much equity ratios need to rise, a number of different approaches are possible. One is to look back in history to see how much equity banks needed before the subsidies were introduced. This suggests that current equity ratios need to triple from around 8% or so to 25% to 30%. (Deutsche Bank had an equity ratio of 30% in 1929 and still needed tax-payers’ support a few years later.) A similar answer is suggested by the data in a recent paper published by the Bank of England.** This shows that UK banks used to have similar returns on equity to other industries but that, more recently, their returns have been around three times the general level. At the same time their equity ratios have collapsed.

Bankers don’t want to lose their subsidies, so they don’t want new regulations which demand large increases in equity ratios. They are also acutely aware that the debate is more about politics than economics and that they have great political clout. For many years banks and bankers have been the largest beneficiaries of the sharply growing gap between average incomes and those at the top. They have been large contributors to the coffers of political parties and individual politicians. As a result they have access to legislators, who are no doubt anxious not to cut off the future flow of finance from this source. Both bankers and politicians are no doubt grateful people and gratitude has been well defined by La Rochefoucauld as “A lively expectation of future favours”. The confidence shown in bankers’ behaviour seems to reflect the pertinence of this dictum.
But such gratitude becomes even more powerful when supported by propaganda and this probably explains why banks have been reducing their equity capital at a time when they clearly need to be massively enhanced. If they added rather than subtracted from their equity in preparation for the new regulations they would be tacitly agreeing to the validity of the reformers’ case. By appearing to believe that their current ratios are unnecessarily high, they hope to make a modest increase, such as 20% to 30%, seem bold and sufficient.

The bankers’ tactics have unpleasant consequences both for the economy and the stock market. The more successful they are at keeping equity ratios low and their subsidy high, the sooner and larger will the next financial crisis be. The impact on the stock market is to make it more volatile. Buying today pushes up share prices and issuing them tomorrow will pull them down. This threat of volatility helps the bankers. The more they buy back their equity today, the greater will be the need to increase it later and the greater will be the threat that the need to raise bank equity by large amounts will cause the next crash on the stock market and the next financial crisis.

*The latest data from the Flow of Funds show that banks’ bought back their equity at an annual rate of $28 bn. in Fourth Quarter of 2009.

**Banking on the State by Piergiorgio Alessandri & Andrew G. Haldane November 2009.