Monday, October 6, 2014

Bank's are no different from other borrowers

Simon Johnson has an excellent article in Project Syndicate where he points to the improper framing of the debate on bank capital requirements. Supporters of higher capital requirements argue that it is necessary to align incentives and ensure that the bankers have their skin in the game, thereby reining in irresponsible lending. Critics claim that higher capital reserves take away from the amount of capital available for lending, thereby adversely affecting the bank's profitability and limiting lending volumes.

Fundamentally, as Simon Johnson argues, the supporters view capital reserves as a liability whereas the critics view it as an asset. When viewed in this frame of reference, the issue gains much needed clarity.

Consider this. When you visit a bank to borrow money to finance your business, the first level of due-diligence for the banker is to examine the share of owner's equity in the total investment. In a balance sheet, this equity is treated as a liability, or what is owed to shareholders. As a rule of thumb, even the most aggressive banker will demand that the owner put in atleast a fifth of the investment as equity. You will find scarce a business owner who complains that this restriction is adversely affecting his business.

In contrast, when it comes to banker's themselves, it appears to be a case of what is sauce for the goose is not sauce for the gander. Banks borrow from depositors. It is therefore only natural that depositors should demand a similar share of owner's equity from their bank borrowers as lenders to other businesses do. The capital base is the cushion that lenders (in this case, depositors) demand from banks. In other words, it is the explicit restriction that lenders place on the bank's leverage. But banker's, oblivious to this and unlike all other business borrowers, feel that this restriction is detrimental to their business prospects. Somewhere in time, bankers have come to forget that depositors are their lenders, and lenders demand capital/equity stake from owners.

In fact, as the Global Capital Index database shows, very few banks have a capital reserve ratio of even 5%. In other words, banks have been borrowing from their lenders (or depositors) by putting forward less than 5% as equity. And now when someone calls out on this egregious anomaly, bankers turn around and cry foul. Clearly, the critics are being disingenuous.

Update 1 (5/11/2014)

A good primer on bank capital ratio is here

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