A bank’s capital ratio is a ratio in which the numerator is a measure of capital (like common equity) and the denominator is a measure of assets (usually risk-weighted assets). Bank executives sometimes take the reciprocal of this ratio and call it “leverage.” More commonly, leverage is defined to be the ratio of debt to equity rather than assets to equity. Any way you define it, higher bank capital ratios mean lower leverage, and vice versa.
Many banks and investment companies seek to attain the highest leverage allowable. If they are constrained to hold a higher capital ratio than a competitor (so that the competitor enjoys greater leverage), they will loudly assert that this gives the competitor a “competitive advantage.” If banks headquartered in the United States are required to hold capital ratios in excess of foreign banks, then it is argued that foreign banks will take over the market.
What is the basis for this claim? Why does management seek to maximize leverage? A first answer is that greater leverage means higher return on equity (ROE). Suppose you have equity of $100 and you buy an asset with a return of $6 per year. Your return on equity is 6%. Then suppose you are able to borrow another $100 at a borrowing cost of 4%. Now your total dollar return will be $6+$2=$8, and your ROE will be 8%. If you could borrow $1,000 at 4% and invest at 6% then your ROE will be 26% (the formula is ROE=Return + Leverage*(Return-Borrowing cost)). So long as your return is greater than your cost of funds, higher leverage means higher ROE.
Of course, if the return turns out to be smaller than borrowing cost, then the effect of greater leverage is to reduce ROE and possibly turn it negative. In the financial crisis, returns did turn strongly negative and many highly levered financial institutions had their capital positions decimated. In the aftermath of the financial crisis many observers have called for higher regulatory capital requirements on banks. Some have called for substantially higher capital levels. Alan Greenspan argues that the capital ratio should rise from 10% to 15%. He believes that 15% is the maximum feasible capital ratio.1 Any requirement greater than this would mean that banks could not attract capital. Financial experts at the Stanford Business School2 dispute the Greenspan logic and support even higher capital requirements. Why not 30% capital?
The answer, according to bankers, is that banks cannot earn an adequate return on equity if equity levels are increased substantially. Let’s suppose that 30% equity to assets became the regulatory minimum. The banker calculation would be something like this: depending on the type of loan, yields net of expected losses may be 4% or 5% today. Assume 5% yield and 1% cost of funds and operating expenses equal to 1% on assets. Then the pre-tax ROE will be
The after-tax return would be well under 10% making the bank unattractive to equity investors.
The academics dismiss this argument. While they agree that average ROE may be lower, they assert that the required return is lower as well; with lower leverage the riskiness of the income stream is lower and so the required return is lower. Besides, if investors want more leverage, they can manufacture it themselves by buying on margin.
A hundred years ago or so, banks in the United States carried substantially greater capital than today, something fairly close to 30%. Back then banks were subject to runs during difficult times. Federal deposit insurance introduced in 1932 largely eliminated the risk of runs and made bankers comfortable with much lower capital levels. To the extent that deposit insurance is underpriced (banks are levied premiums proportional to the amount of insured deposits), deposit insurance is a subsidy and bank shareholders naturally support maximizing the subsidy.
The problem with low capital levels is that even modest loan losses jeopardize the soundness of banks thereby threatening financial stability. Economists call this a “negative externality.” Since the largest banks are too big to fail, this means the taxpayer is on the hook to bail out creditors of these banks. According to the professors, a primary benefit of dramatically higher capital levels for banks is that the negative externality is reduced and so is the taxpayer subsidy. The financial system would be much less prone to instability.
But even if you agree that the financial system would be stronger if large banks held more capital, the problem is that we have to get from here to there. Bank assets today are approximately $11 trillion and bank equity capital is about $1.3 trillion. Assuming that assets stayed the same, then banks would need to raise approximately $2 trillion of equity in order to meet a 30% equity to asset standard. If such a standard were to be imposed, it would require a very long phase-in period. Admati, et.al., assert that a clear policy implication is that regulators should prevent banks from paying dividends, buying back stock or making other equity payouts until higher capital levels are achieved. If imposed, this restriction probably would not help entice investors to buy bank stocks.
1 Alan Greenspan. On the crisis. 2009.
2 Admanti, DeMarzo, Hellwig, and Pfleiderer. Why bank capital is not expensive. Stanford Graduate School of Business Research Paper. 2010.