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Leverage revisited: when fortune doesn't favor the brave

Leverage revisited: when fortune doesn't favor the brave Anthony Harrington

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It is amazing how, starting with the simple, practical financial fact that debt is cheaper than equity, the world managed to end up with the world-class financial crash of 2008. Banks, which can be correctly viewed as highly leveraged institutions whose business is to enable other organizations to leverage themselves up in turn, were clearly at the heart of the 2008 crash. What brought the whole house of cards tumbling down was simply the sheer number of organizations, supposedly steered by the brightest and the best, who leveraged themselves to the hilt and took dodgy bets they couldn't afford. Stupid? You bet! But there is something in the whole dynamic of leverage that lends itself to this folly, and this is at the heart of what the Basel Committee on Banking Supervision has been wrestling with in shaping the new regulatory regime.

It wasn't supposed to be like this. The whole art of banking is supposed to be about understanding credit risk. Bankers lend money at a rate of return that makes it extremely costly for them when, as must inevitably happen from time to time, the organization they are lending to defaults. They have to lend an awful lot of money out to cover one default, at a ratio of say, 20 to one or more if you add into the equation the fact that they need to cover their own running costs as well as recoup the lost debt. By way of contrast, a venture capital firm only needs around one in four or one in five of its "bets" to come up trumps to cover its costs and generate a reasonable profit for its investors. So bank managers (or credit committees) who make errors of judgement in their lending do not thrive in their organizations. This constrains their behavior and makes them more risk averse, as it should.

However, let us resume the story. Banks borrow easy money on easy terms from the central bank, which is just printing the stuff anyway, and they lend it out at modest rates to fuel the engine of the economy. If everyone sticks to the rules, the system works and we get moderate rates of growth in advanced markets. The banks make a steady profit on this basis and grow in an unspectacular but steady fashion. And therein lies the rub.

Being at the heart of the economy, it inevitably occurs to bankers and their investors that banks could, oh, be a lot more exciting than this. Instead of grinding along like a utility stock, they could use their ready access to capital - both debt and depositor cash - to do more exciting things. Banks who took this route in the boom times before the crash, were rewarded with stellar growth and a rocketing share price that excited their investors. And of course, their growth was built on piling on the leverage, with ruin to follow.

Reflecting on all this, Stefan Ingves, Chairman of the Basel Committee on Banking Supervision, used his keynote address to the 10th Asia-Pacific High-Level meeting on Banking Supervision to elucidate the Committee's thinking on the leverage ratio in Basel III. The ratio, he pointed out, is meant to be a back-stop or safety net - but, to be an effective safety net, it has to act from time to time as a constraint on bankers' behavior. "Thus far, and no further" is the general idea.

Ingves starts his speech with the simple fact that we began with. The reason why debt will always be cheaper than equity, he pointed out, is that a deeply ingrained practice in the relationship between government and business, all round the world, is to allow the interest paid on debt to be offset against taxable income. Government agrees to forego its share of that cash in order to oil the wheels of commerce and promote growth, which will, it is hoped, generate sufficient growth to make up for the taxes that the government has given up. But of course, in making debt "cheap", the tax break also lays the seeds for folly, because it lowers the cost to a company of mis-allocating capital. Mistakes can be recovered from because the cost is not that high.

Hmmm. We seem to be in a contradictory argument here. Remember, we argued earlier that what makes banks careful and cautious lenders is precisely the fact that the cost of failure to them is extremely high. If they can just borrow more on the cheap and roll the dice on a whole bunch of new loans, then the cost of a mistake, or a whole bunch of mistakes, can seem inconsequential - at the expense of piling on the leverage.

So, the Committee naturally wants to constrain leverage, which will have the effect of keeping banks "real"; but, if they overdo the constraint, then banks rapidly become too risk averse - particularly when you add in the Committee's second "ploy", namely making the banks set aside capital reserves to fund their risk positions. When banks become risk averse they choke off growth in the economy. Not good. Therefore, the Committee is on a high wire act over the void in trying to set an "appropriate" level of leverage. It is quite possible that only God knows - and if she does, she's not telling - where this mythical "appropriate" level actually lies. What is certain is that any level the Committee finishes up with is either going to look like too much of a constraint to most of its constituency, or an ineffectual gesture to most of its critics.

Companies, Ingves points out, generally go for no more than a 50:50 debt-to-equity ratio. Banks, on the other hand, typically operate at a 95:5 ratio, before off-balance sheet exposures (which, at the height of the 2007/2008 boom, were sky high). Why do we allow fractional reserve banking, knowing the dangers this produces? Borrowing Winston Churchill's joke about democracy, Ingves told his audience that the only reason we tolerate fractional reserve banking, knowing how bad it is, is that it is still better than any other form of banking. Which leaves the Basel Committee trying to set an "appropriate" level of leverage. Good luck Ingves...

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Further reading on banks and the crash:

Tags: banking sector , Basel Committee on Banking Supervision , debt , equity , leverage , Stefan Ingves
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