The Banker's New Clothes

I am a big fan of the new book The Bankers New Clothes by Anat Admati and Martin Hellwig. Their basic argument is that large financial institutions in the United States are able to borrow at artificially low interest rates because their creditors expect to be bailed out by the government if anything goes wrong. As a result, banks disproportionately fund themselves through debt rather than equity. This creates a banking system that is excessively leveraged and fragile. In order to resolve this problem, Congress should require financial institutions that are "too big to fail" to get 20-30% of their funding from equity (many banks are currently at 3%). 

There is a lot of good discussion about this book on the blogosphere, but I wanted to respond to one argument made by Raghuram Rajan:

The critics’ arguments about the benefits of equity are equally unsatisfying. Of course, given a set of bank assets, more equity would reduce the risk of failure. But failure is not always a bad thing; a banker operating an all-equity bank, with no need ever to repay investors, would be likelier to take unwarranted risk. The need to repay or roll over debt imposes discipline, giving the banker a stronger incentive to manage risk carefully. 

The problem with this argument is that it doesn't explain why banks are different in this regard than other large corporations. Apple doesn't have any debt, yet presumably the managers of Apple still have incentives (reputational, they could be fired, etc.) to appropriately manage risk and create profit for their shareholders. This is how it is for a lot of companies in America, most of whom don't need to roll over a large amount of short term debt on a regular basis.

If anything, having to roll over debt on a regular basis skews bank managers towards investing in assets that have a liquid market and can be unloaded easily. This causes them to avoid acquiring illiquid assets, like long-term loans and investments, even if they would be more profitable for shareholders, safer and better for the bank in the long run.

Finally, at a certain level its just hard to really imagine that all of these bank managers would be opposing higher capital requirements, if the effect of these requirements was that they would be able to take far more risk. It seems more likely they would be forced to run safer, less profitable banks, because losses would accrue to shareholders, rather than the public.