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Charles Goodhart

April 30th, 2024

The continuing financial fragility of banks

0 comments | 27 shares

Estimated reading time: 5 minutes

Charles Goodhart

April 30th, 2024

The continuing financial fragility of banks

0 comments | 27 shares

Estimated reading time: 5 minutes

Banks remain fragile, which could be reduced if they held more equity and less debt. Bankers, however, fear this could affect their compensation packages. Commercial banks are likely to win the political debate, except if there is another financial crisis causing the need for further reform to become acutely pressing. Charles Goodhart writes that we need to consider what else might be possible if the preferred solution is politically unfeasible.


Charles Goodhart will be speaking with Anat Admati in the LSE Event:

Anat Admati and Martin Hellwig have taken the opportunity of the banking failures of Spring 2023 to add a new part with four additional chapters to their 2013 book The Bankers’ New Clothes. The earlier hopes that the adoption of bail-in proposals would end bailouts by the taxpayer, and that this and further regulatory measures would suffice to keep banks healthy, have proved nugatory. The US authorities, instead, protected all uninsured depositors.

The cost of this did not fall on bail-in-able creditors, but rather on the Federal Deposit Insurance Corporation (FDIC) and hence on all banks, whether risky or risk-averse, and then on their clients, probably leading to a higher wedge between deposit and lending rates. Similarly, the resolution of the weakness of Credit Suisse did not lead to the cost falling on the agreed ladder of creditors, but rather the equity holders got some protection at the expense of greater loss being imposed on junior debtors.

Admati and Hellwig are correct when they note that our banking systems remain fragile and that such fragility could be greatly reduced if banks became less levered, with significantly more equity and less debt. In principle, this should leave profitability and the net worth of commercial banks unchanged, with the payment of more dividends on a wider equity base being offset by a reduction in interest payments, both from a lower level of debt and lower interest rates, since debt would now be safer.

In practice, however, most debt holders, who are supposed to be loss absorbing, now believe that when push comes to shove, the authorities will save them. So, requiring more equity will probably not lessen the interest rate that banks have to offer on longer-term debt. Also, interest payments have a tax advantage relative to dividends on equity.

Anyhow, right or wrong, bankers themselves believe that the requirement for more equity would reduce the resultant return on equity, which forms the basis for their own bonuses and payment, what gives them their personal incentive. So, they strongly, indeed vehemently, oppose suggestions for significant increases in regulatory equity above present levels.  And they argue that any increase in required equity above present levels would lead to financial intermediation being shifted either offshore, or to non-bank financial intermediaries, both of whom are often less well regulated.

They claim that further increases in bank regulation would not, when you look at the general equilibrium outcome, necessarily make our financial systems safer. Commercial banks have much more influence and monetary power than reformers like Admati and Hellwig, and the lesson of history is that these banks are likely to win the political debate, except and unless there should be another financial crisis causing the need for further reform to become acutely pressing.

My conclusion, though perhaps pessimistic, is that absent yet further financial crises, which no one wants, the likelihood of getting significantly greater increases in equity requirements on banks passed through our political systems is very low. That suggests to me that we need to seek whether there are alternative measures that could be taken, that might be better placed to overcome political hurdles.

A concern is often expressed that insurance, notably deposit insurance, leads to moral hazard. What is much less frequently appreciated is that limited liability leads to exactly the same moral hazard, since it means that shareholders are protected from serious loss. With the financial rewards to bankers in the form of bonuses and pay being strongly correlated with share values, the limited liability that bank executives get strongly encourages them to take on strategies with much greater risk of either a very high, or very low, return. That same incentive structure encourages bankers to manipulate their internal models and published accounts in order to understate the underlying risk, because if that risk should eventuate, the cost to them would be limited.

For such reasons, I have advocated in several articles that an alternative to higher required equity regulation would be to remove the benefits of limited liability from bank executives and to replace it with multiple, even perhaps unlimited, liability for them. While banking executives would not welcome this, they might be less averse to it than to further equity regulation. Senior bankers are probably unlikely to believe that they personally would ever meet such a costly outcome and they could probably claim that they needed a higher regular payment to offset such a risk, which they would expect to obtain.

What I had not appreciated before the events in the US last spring, was the sheer scale of uninsured deposits in the American banking system. As of the end of 2023, these amounted to $9.2 trillion, around 40 per cent of total deposits. Moreover, these are held by the most informed and inter-communicative depositors, who are most likely to run. While a slow withdrawal of funding by informed creditors could provide information to regulators and warn them of trouble ahead, runs by uninsured depositors can now be so fast as to occur well before the supervisors/regulators can put together a response. One further reform that we do need is some mechanism for slowing the speed of withdrawals by uninsured depositors; that should be possible.

One way or another, there is still a need to make the financial system safer. While Admati and Hellwig are correct in their analysis of the continuing fragility of the financial system, we do need to consider what else might be possible if their preferred solution is blocked politically by the powers that be.

 


  • This blog post represents the views of the author(s), not the position of LSE Business Review or the London School of Economics and Political Science.
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About the author

Charles Goodhart

Charles Goodhart, CBE, FBA is Emeritus Professor of Banking and Finance with the Financial Markets Group at LSE, having previously, 1987-2005, been its Deputy Director. Until his retirement in 2002, he had been the Norman Sosnow Professor of Banking and Finance at LSE since 1985.  Before then, he had worked at the Bank of England for seventeen years as a monetary adviser, becoming a Chief Adviser in 1980.  In 1997 he was appointed one of the outside independent members of the Bank of England's new Monetary Policy Committee until May 2000. Earlier he had taught at Cambridge and LSE.  Besides numerous articles, he has written a number of books, such as The Basel Committee on Banking Supervision: A History of the Early Years, 1974-1997, (2011), and The Regulatory Response to the Financial Crisis, (2009).

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