Banks fail to convince crying foul over Basel reforms

By David Miles

Published: November 23 2010 22:42 | Last updated: November 23 2010 22:42

The debate about the economic impact of higher bank capital requirements has heated up. Basel III will require banks to boost their highest quality equity capital from 2 to 7 per cent by 2019, to create a buffer against losses. Mervyn King, in a recent speech in New York, suggested that even large increases in capital would have only a small impact on bank funding costs. But analysts at UBS recently seemed to imply that it would push banks’ costs much higher. Vikram Pandit, head of Citibank, appeared to agree when he argued in the Financial Times that banks and their customers would be harmed by higher capital ratios. That is a complaint widely shared in the industry, but one that does not hold up under scrutiny.

Today the rate of return required by existing bank shareholders is indeed high. But the reason for that is not some intrinsic feature of equity financing. Rather it is because the leverage of banks is currently exceptionally high too. And this, in turn, is why those who see bank funding costs rising much higher if they are forced to hold a lot more equity are far too pessimistic.

Banks in recent years have bought assets using only a thin sliver of capital – that is equity, capable of absorbing losses – and a huge amount of debt. Leverage ratios of 30 and more were common; a level many times higher than most non-financial firms. But this means that even small variations in asset values turn into much larger fluctuations in the value of their equity. And it is that risk which needs to be compensated for with a higher average return on equity.

Given their leverage, therefore, it is not surprising that holders of bank equity expect high returns. But it does not follow that if banks are forced to hold significantly more equity their overall cost of funds is bound to be higher. As banks hold more equity their leverage will fall – and if they originally held only a sliver even a small increase in equity will bring down their leverage sharply. And that should significantly reduce the required rate of return on both existing and new equity.

Fail to factor this in to any analysis, and one would dramatically overstate the impact of reforms like Basel III on bank funding costs. Indeed, the logic of a widely used theory of how companies are funded – the so-called Modigliani Miller theorem – suggests that the impact of lower leverage is such that the effect on bank funding from raising what looks like “expensive” equity is actually close to zero.

Some ignore this idea completely, but more sophisticated thinkers – like the analysts at UBS – accept that there may be some benefit to banks holding more equity. It is just they seem to think that, in the real world, the effect of this, in theory, cannot be large enough to prevent the cost from funding rising. Yet this thinking has a crucial flaw. True, even a substantial cut in UK bank leverage would leave leverage ratios well above other UK companies. But it does not follow that banks who take fewer risks would also still be required to earn a rate of return on equity in excess of that which is typical for non-banks.

The real question is: what would happen to equity costs (and thus to the cost of funds) if banks left their asset portfolio unchanged, and instead switched some funding from debt to equity? The UBS analysis asks a different question: what might happen if there was a switch in funding, and also simultaneously a switch in assets so that they were similar to those of a typical UK company. But that would make bank assets much more risky.

The Modigliani Miller logic is powerful. It shows that if a company has a lot of assets, but is funded with only a little bit of equity (meaning that leverage is high) then small shifts in asset values create big shifts in equity value – and that shareholders care about this volatility. It also suggests that the impact on long-run funding costs to banks of having to hold more equity are likely to be small, because the return required on that equity will be lower too.

Those who think this theory wrong in practice must explain which part of it, and the assumptions behind it, they think flawed. Is it that higher leverage does not create greater volatility in the value of equity? Or is it that holders of equity do not really expect greater returns if investments are more risky? If they can disprove neither of these, their assertions on the danger of higher bank funding costs are not convincing.

The writer is a member of the Bank of England’s monetary policy committee