Even as the US economy struggles to recover from a recession, the analysis of causes continues unabated. In the growing literature on the 2007-08 financial crises, The Banker’s New Clothes: What’s wrong with banking and what to do about it , by Anat Admati and Martin Hellweig (Princeton University Press, New Jersey, 2013), is a significant addition. Admati and Hellweig identify low equity of banks as single most important cause of the crisis.

The book demolishes the case to treat bank leverage as a problem in itself and explains how raising more equity by banks is necessary and possible. Overleveraging by business firms plays an important role in explaining business fluctuations. A leverage ratio of 10 to 12 is considered quite normal and healthy as compared to non-banking companies, where debt-equity ratio of higher than 2 or 3 would be considered risky. Banks with low capital ratios are more risk-prone.

The book develops a case for increasing bank capital to higher levels than stipulated under Basel 3. Banks should target capital ratios of 20-30 per cent, higher than Basel 3 stipulated levels.

Yet, the authors beg to differ with arguments, often extended by banks themselves, that the equity is costly; higher equity ratios would increase the cost of funds to borrowers, and may also reduce the aggregate flow of credit to desired segments. They find no reason to treat banks differently from other manufacturing/service companies, which also have to choose between debt and equity. If equity is indeed costly, how is it that businesses that run on low or zero debt remain profitable?

COST OF EQUITY

The present situation, where banks are overleveraged, allows bank managements to achieve extra-large growth. The stipulation of higher equity, even if it leads to moderate growth of the financial sector in near future, would ultimately be beneficial to society, the authors argue.

Their suggestions that banks should not pay dividend till the desired capital ratios are arrived, is indeed harsh to investors and it’s not clear how they would react to a dividend freeze. Even while agreeing to increase the common equity capital of banks, the case to keep the pace of change moderate depends on macro economic factors such as whether the primary equity market can cope with such large requirements. But the authors seem to focus on micro effects of higher capital requirements; they seem to suggest that banks, which are in better shape, would be successful in raising additional equity.

INDIAN CONTEXT

For Indian readers, the distinction between macro-micro effects of higher equity requirements for banks as stipulated under Basel 3 norms is important. As the Government owns a sizeable portion of banking system, any increase in regulatory capital requirements translates into a demand on the government budget. In the Budget for 2013-14, the GOI has provided Rs. 14,000 crore for subscription to fresh bank capital. Given significant difference in the borrowing cost of government (say 8 per cent) and the current dividend yield on bank shares (3-4 per cent) capital support to banks would have a significant and sustained macroeconomic effect in terms of higher fiscal deficit.

Moreover, it is not obvious or known whether government is able to distinguish between different types of banks, or what are the criteria used by the government in allocating capital to banks. If capital is allocated to all banks, irrespective of their performance, the micro-economic disciplinary effects, namely, better banks getting easier access to capital, will not be operative.

(The author is Chief General Manager, IDBI Bank.)

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