Heavy Borrowing is Addictive and Harmful for Banks, as Well as the Public, Say Stanford Researchers

STANFORD, Calif.--()--In the book she coauthored, The Bankers’ New Clothes , Stanford Graduate School of Business faculty member Anat Admati argued that excessive bank borrowing created a fragile financial system ripe for crisis, and called for effective regulation to correct it.

Unless government regulators force the banks to increase their reliance on equity — money from their owners and shareholders — Admati and her coauthor Martin Hellwig of the Max Planck Institute warned that banks would continue to pose a threat to taxpayers, to financial stability, and to the economy itself.

In a new paper, the two authors join forces with corporate finance experts Paul Pfleiderer and Peter DeMarzo, both professors of finance at Stanford Graduate School of Business. Together, they add a new twist to the argument: Equity requirements aren’t just good for the public at large; they are also good for the banks.

In this latest work, the researchers contend that highly indebted borrowers, including virtually all banks, develop an “addiction” to ever-higher borrowing — even when it lowers the total value of the firm to investors. Creditors know that the over-borrowing is dangerous to their interests, but Admati and her coauthors argue equity shareholders have powerful incentives to resist debt reduction and indeed to have a company borrow even more. In the case of banks, where creditors are often protected by government backstops, shareholders are especially likely to trump creditors. The authors call this the “leverage ratchet effect”: an almost inherent tendency of bank debt to rise rather than to fall.

“Not only will shareholders choose not to [take actions to] reduce leverage, they will always prefer to increase leverage,” write the researchers.

This argument flies in the face of traditional corporate-finance theory, which generally holds that companies select their mix of funding to maximize the total value of the firm. But the researchers say the traditional theories do not adequately recognize how shareholders (or managers acting on their behalf) actually calculate their own self-interest in making those decisions over many years.

The key reason for the “addiction” to borrowing, the authors of the new paper argue, is that debt reduction entails shareholders giving a gift to creditors by taking on more downside risk and making the debt safer at the shareholders’ expense. If a bank wants to buy back its bonds, for example, bondholders will demand more than just the current market price of those bonds. The bondholders will also insist that the buyback price reflect the fact that the remaining debt will have a higher value after the buyback, because the company will be at less risk of defaulting. In other words, bondholders get all the benefits of debt reduction, but shareholders have to foot the cost upfront. To shareholders, that’s a clear disincentive.

The researchers say the “leverage ratchet” is especially relevant for banks. That’s because banks creditors are shielded by government backstops and thus less worried about default than creditors for nonfinancial companies.

For insured depositors, there is deposit insurance. Other creditors, such as the bondholders and counterparties of the largest banks, have reason to believe that the government will bail them out in order to prevent another financial meltdown. That, says Admati, is why it’s so important for regulators to step in forcefully and protect the deposit insurance fund and the broader public.

Overborrowing by banks, says Admati, leads to many problems, including a tendency to underinvest in good lending opportunities and be biased in favor of gambles with more “upside.” For society, there is also the risk that taxpayers will have to foot the bill if a major financial institution appears poised to fail.

Admati compares the decisions of an over-leveraged bank to those of a homeowner struggling to pay the mortgage. The homeowner may avoid putting any more equity into the house, because he or she would lose it all if he defaults, benefiting the banks that made the mortgage. The homeowner may even choose to borrow more money, perhaps by taking out a second mortgage or a home equity loan, because the risk of that additional debt falls on the creditors.

To be sure, shareholders and creditors understand that overborrowing is dangerous, just as an addict knows that cocaine is self-destructive. To protect themselves, creditors often impose “covenants,” or conditions aimed at limiting a company’s future risk taking and borrowing. In practice, however, the authors say such covenants usually include enough flexibility to let the borrowers run up more debt if they want to. This is what Pfleiderer calls a “commitment” problem: the fact that shareholders are not committed to what they would do or not do at a later time.

Once the debt is in place, shareholders will be guided by what is best for them and, within the limits of what they are allowed to do, ignore the impact on creditors. Regulators in the United States and abroad are pushing banks to increase equity as a share of their total assets, but Admati and her coauthors say the levels are far from sufficient. For bank holding companies in the United States, recent proposals would still allow debt to account for up to 95 percent of a bank’s assets. Even without regulation, nonfinancial corporations in the United States have, on average, only about 30 percent debt relative to their assets.

Don’t expect the banking industry to have an epiphany. Five years after the global financial meltdown, banks are still benefiting from easy borrowing, and fighting tougher equity requirements and other regulations tooth and nail.

For further details, the research team’s paper, “The Leverage Ratchet Effect,” is available online.

Contacts

Stanford Graduate School of Business
Katie Pandes, 650-724-9152
pandes_katie@gsb.stanford.edu

Release Summary

Stanford researchers find that banks and their shareholders become ever more addicted to borrowing in a "ratchet effect" that actually decreases the company's overall value.

Contacts

Stanford Graduate School of Business
Katie Pandes, 650-724-9152
pandes_katie@gsb.stanford.edu