Center for Social Innovation

When the financial markets crashed two years ago, Americans discovered that all too many banks and financial institutions became distressed because of their high degree of leverage. Since then, regulators, economists, and the banking industry have jousted over the question of how much equity capital banks should hold.

The prevailing argument by the industry and its allies is that raising equity requirements will weaken banks and raise the cost of borrowing for everyone because "equity is expensive." But is that really the case?

In a new, and likely to be controversial, research paper, Anat Admati, of the Stanford Graduate School of Business, and her colleagues argue that this is not the case. "Quite simply, bank equity is not expensive from a social perspective, and high leverage is not required in order for banks to perform all their socially valuable functions, including lending, taking deposits, and issuing money-like securities," they wrote.

What's more, the researchers argue, raising capital requirements would produce widespread social benefits as well: "Our analysis leads us to conclude that, starting from current capital requirements, the social benefits associated with significantly increased equity requirements are large, while the social costs, if any, are small."

"Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity Is Not Expensive," a research paper exploring the question, was written in August 2010, by Peter M. DeMarzo, Paul C. Pfleiderer, and Admati, all faculty at the Stanford Graduate School of Business, and Martin F. Hellwig of the Max Planck Institute for Research on Collective Goods in Bonn, Germany. The policy paper was designed to be part of the ongoing debate over financial regulation, said Admati, the George G.C. Parker Professor of Finance and Economics.

The paper rebuts some of the most common arguments against higher equity requirements, calling on regulators to raise them significantly and to exert stricter control over equity payouts by banks.

As discussed in the paper, equity capital represents the share of the firm's total value held by shareholders in the form of common stock. Equity capital requirements therefore do not require banks to "set aside" funds rather than use them to make productive loans, a common misconception. (Many firms, such as Apple, are virtually 100% equity financed, and this does not constrain their ability to invest.)

"As a result, these equity requirements can be used to improve the safety of the banking system and the overall economy without sacrificing growth; indeed, by reducing the risk of a future crisis, growth would likely be enhanced," says Admati.

The paper does not argue for a specific level of equity capital, but instead stresses that regulators should stop fearing its use. "The answer isn't a magic number, it's a different mindset," said Admati. World banking regulators, at a meeting in Basel, Switzerland, in mid-September, agreed to raise the amount of common equity required for banks to 4.5% (with a buffer that takes it up to 7% at times) of assets from about 2%. Admati and coauthor DeMarzo said in an interview that while they believe this is a step in the right direction, they believe that equity capital requirements should be raised even further, and they were critical of the long phase-in period included in the Basel proposal (the full requirements will not take effect until 2019).

Key Arguments

Here are some of the key arguments made by opponents of higher equity requirements—and the response by the researchers:

• The banking industry argues that increased equity requirements will increase their funding costs because equity is risky and requires a higher return. Forcing banks to use more expensive equity drives up their costs, and these will be passed on to borrowers, they say. They are also concerned with the fact that increased equity requirements would lower the return on equity (ROE) of banks.

That argument is "fundamentally flawed," the researchers maintain. When leverage—the degree to which an institution is using debt relative to equity to finance its operation — is reduced, the riskiness of equity is also reduced. That, in turn, has the effect of lowering the cost of equity and, appropriately, the average return on equity. This does not by itself indicate any change in the value of banks to their shareholders.

• Banks prefer debt financing over equity because, by doing so, they lower the amount of taxes they pay and also enjoy the benefits of implicit guarantees by the government.

The researchers don't dispute that debt is more attractive for banks because of these government subsidies. However, if higher equity requirements make funding more expensive, this represents a private cost to the banks, and not a social cost to society. "It is true that government policies subsidize debt financing and thereby penalize equity financing. But this is definitely not a reason to allow banks to continue to have dangerously high levels of leverage," they write.

• Increasing equity requirements would force banks to reduce lending and perhaps other socially desirable activities, the industry argues.

Admati and her colleagues believe that this argument is incorrect for a number of reasons. Banks, for example, can issue additional equity to meet higher capital requirements and use those funds to lend. "Banks' current avoidance of raising new equity capital is entirely due to the fact that they are already highly leveraged, and new capital will primarily help their existing creditors" they argue. Once better capitalized, banks' ability to provide social value would be enhanced because they would be less likely to make excessively risky investments or to pass up valuable investments.

The researchers' proposals for fixing the problem:

• Regulators must set significantly higher equity requirements. To help in the transition, the researchers suggested restricting bank dividend payouts for a period of time. This will help banks increase their equity capital quickly and efficiently and provide them with additional funds, suitable for lending. "U.S. banks paid about $130 billion in dividends since the crisis. If withholding dividends is done under the force of regulation, there will not be a stigma for any individual bank," says Admati.

• Higher equity requirements are superior to a "bailout fund" supported by bank taxes. Equity requirements, as a form of self-insurance, would be priced directly by financial markets.

• Any subsidies given to banks should not encourage leverage but should be given in ways that subsidize socially valuable lending activities.

There's been discussion in regulatory circles of using contingent capital as a tool to make banks more stable. Contingent capital is debt that would convert to equity under some conditions. Admati and coauthors argue, however, that "contingent capital looks attractive relative to debt but it has not been properly compared to alternatives that include equity. Since there are many complications associated with contingent capital, approaches based on equity are preferable and would provide more reliable cushions."

— Bill Snyder