The Inevitable Challenge of Financial Leverage in Modern Banking
VK Sharma , Former Executive Director , Reserve Bank of India
The inevitability of the challenge of public policy having to countenance higher, but not excessive, financial leverage in banks relative to that in non-bank corporates, arises from the public policy imperative of efficient and effective transmission of monetary policy in the larger interest , in turn, of the public policy imperative of a globally competitive and efficient real economy, in which modern banks play a critical intermediation role .
( The author’s paper in the Colloquium in April- June 2015 issue of Vikalpa, The Journal for Decision Makers , published by Indian Institute of Management, Ahmedabad http://vik.sagepub.com/ )
To see why higher financial leverage in modern banks is inevitable for efficient and effective transmission of monetary policy is to consider the extreme case of Equity Multiplier of 1 which means the entire assets of a bank are funded by common equity only . To deliver market competitive equilibrium RoE ( Return on Equity)of ,say 14%, a bank’s RoA ( Return on Assets) will also have to be 14% . So , even if policy rate be 1% , banks will, no matter what , lend at 14% plus only , and no lower ! Modern, competitive, safe, sound and efficient banks have typically operated on an RoA of 1% and EM of 14 times delivering RoE of 14% . Thus both modern banks and non bank corporates have generally delivered market competitive equilibrium RoE of 14% with their financial leverage, as measured by Equity Multiplier, poles apart ! But those who swear by the Modigliani-Miller Theorem aver that such higher financial leverage in banks relative to that in non-bank corporates will not work because higher leverage, or so much lower nominal common equity, will make cost of bank debt/deposits higher. But in what he believes a first, the author provides a very original insight that lower nominal common equity is complemented by what the author calls “quasi equity” comprising 1) effective and credible bank supervision/regulation, 2) deposit insurance 3) implicit taxpayer guarantee and 4) a central bank’s lender of last resort function ! Of course, another name for all these fouris the so-called “moral hazard”! And, in fact, the author argues that this “quasi equity” brings banks on par with non-bank corporates in terms of equity and, thus, makes the business model of modern banks consistent with the Modigliani-Miller Theorem, one for one! Thus, the author shows that while , in terms of nominal common equity, banks and non-bank corporates are poles apart, in terms of being compliant with the Modigliani-Miller Theorem, they both become identical as both deliver similar market competitive equilibrium Return on Equity (RoE), in spite of way too diverging financial leverage , because they both have necessarily to compete in the same capital markets for raising equity capital !
4. If only to complete the story of the inevitability of the challenge of financial leverage in modern banking and central banking , it would only be appropriate to put it in historical perspective . Specifically , in the mid 1800s, Danish banks had leverage ratio( inverse of EM) of 75% , Americans had 55% and European ones had 25% in early 1900s cf The Economist of 12 November 2012 " How much capital banks had when they had choice" ! In other words, banks then had roughly the same business model as non bank corporates have today ! And significantly, monetary economics, monetary policy and modern central banking with lender of last resort function and bank regulation and supervision and deposit insurance , as we know them today , were nonexistent then and followed only later in the late 1800s and early 1900s, and ,so did with them, the challenge of the inevitability of higher financial leverage ! And from there , it took about a century to reach Basel 2 which prescribed capital adequacy , not in terms of common equity as a percentage of total assets( leverage ratio) , but risk- weighted assets ,quite apart from introducing the so-called Tier 2 debt capital , thus sowing the seeds of the worst global financial crisis what with financial leverage in global banks , reachingfrom less than 2 times ( leverage ratio of more than 50% ) in the early twentieth century to more than 50 times ( leverage ratio of less than 2% ) in the early twenty first century ! This happened because pre crisis global banks ,in spite of being compliant with Basel 2 on a risk weighted basis ( capital adequacy of 8%) , had risk weighted assets of only 20% of their actual total assets which had the effect of increasing their financial leverage, measured by Equity Multiplier , by 5 times ( leverage ratio of less than 2% as noted above ) !
But then, there is no free lunch; there is a price to be paid by economic agents and stakeholders in the form of effective and credible bank supervision/regulation which, significantly, depending upon how effective and credible it is, reduces potential recourse to the other three moral hazards of deposit insurance , taxpayer-funded bailout and central bank as lender of last resort ! The challenge of higher financial leverage in modern banking is inevitable given the imperative of efficient and effective monetary policy transmission in the real economy so that borrowing costs in the real economy are higher not because of lower financial leverage/ higher leverage ratio but largely, if not only , because of higher monetary policy rates and vice versa ! This is precisely here that the synergies between monetary policy , credible and effective banking supervision and , no less , lender of last resort function , come in and which is why banking supervision was taken away from the now defunct Financial Services Authority and given back to the Bank of England after the crisis . In decisively and deftly managing the inevitable challenge of leverage in modern banking , effective and credible supervision makes for efficient and effective monetary policy transmission and , in the process , makes for a globally competitive and efficient real economy ! In other words, there is a trade off between leverage and effective, credible, proactive, preemptive , and even intrusive, supervision of banks. In other words, the more effective and credible the supervision, the higher the leverage threshold can be and vice versa ! The higher regulatory capital,or lower leverage, is the cost of supervisory failure,, inertia and inaction imposed on banks but borne by the real economy ! To make this seemingly heretical statement realistic , one can make leverage subject to a ceiling as indeed, as we have seen above , Basel 3 has done ; only this ceiling or limit is limited only by the fallibility of those in charge of banking supervision ! So to conclude , to prevent a repeat of the worst global financial crisis , what we need more than, and beyond, Basel 1,2,3,4.......is supervisory temper,culture and attitude !
Significantly, and hearteningly, to the credit of the RBI and the Indian banking sector, Indian banks collectively have an average leverage ratio ( inverse of EM) of 7%+ which, at about 2.5 times, is way higher than 3% mandated under Basel 3 capital rules to be complied with only in 2018 ! Incidentally, but significantly, Indian banks being already 2.5 times Basel 3 compliant with leverage ratio of 7% + will need to increase equity capital only to maintain their existing leverage ratio i.e to remain compliant with themselves and not at all to comply with Basel 3 as is widely , but erroneously, made out in many quarters ! This conclusion will very much be valid even if the denominator of the leverage ratio is inflated to include all off balance sheet liabilities which ,in the case of Indian banks, are about 100% of the aggregate assets because this will only reduce the leverage ratio from 7%+ to 3.5%+ which is still higher than Basel 3 requirement of 3% ! I
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