“Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity Is Not Expensive”
Real Reasons Bankers Don’t Like Basel’s Rules: Clive Crook – Bloomberg. Why bankers’ whining about higher equity requirements is just that:
A much-cited paper by Stanford’s Anat Admati and colleagues — “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity Is Not Expensive” — should have ended this debate once and for all. It dismantles the banks’ position step by painstaking step.
The study makes the crucial distinction between the interests of bank managers, bank shareholders and the public at large. Managers are being disingenuous. They do have reasons, valid after a fashion, for opposing higher capital requirements, just not reasons they can admit. The one they emphasize — cost of funding and its effect on future lending — is fit for public use, but bogus.
What might their real reasons be? If banks sell more shares, it’s true that the return on equity will fall. If managers’ pay is tied to return on equity (as it often is), they will be worse off. Shareholders, on the other hand, shouldn’t mind, because the risk of their investment is reduced in proportion. Taxpayers, of course, would be better off — less likely to be stuck at some point with the cost of bailing out the bank.
The paper is here.
Cross-posted at Asymptosis.
“Shareholders, on the other hand, shouldn’t mind, because the risk of their investment is reduced in proportion.” – on so many levels this is FALSE
So the ivory tower argument in theory should be true. Greater capital should reduce tail risk of bankruptcy, lower the volatility of earnings, and therefore reduce cost of equity capital. The reduction in the cost of equity capital would lead to a higher multiple attributed to the stock per dollar of earnings or book value. But shareholders have seen the exact opposite happen and with a much greater elasticity to the cost of capital than what that article states.
If we’re going to ivory tower theory here, the P/E of a stock equates to the following formula: P/E = 1+(1/(r-g))*(1+g-((1+r)*g)/ROE), where r is the cost of equity capital, g is the long-term growth rate of earnings, and ROE is return on equity. Earnings are [Book Value Per Share] * ROE, so P/BVPS= ROE * the right-hand side of the above formula.
JP Morgan, widely regarded as the best managed and most well-capitalized of the mega banks is trading at around 75% of BVPS. Assume that sustainable earnings growth in perpetuity is 2.5%, and using the 9% ROE they’ve posted this year results in an r of around 12.5%, or 10.5% above the 10-year Treasury. If the equity risk premium is somewhere between 4-6%, this implies that JP Morgan’s beta is roughly 2x. But if the excess capital is turning the banks into slow growth, low ROE, low volatility companies, beta should be coming down rather than increasing. If the market assigned a beta of 1 to JPM, the same exercise would get you to a P/B multiple more than double (and hence so would the stock price) where it trades right now for the same ROE. Even if the market assumed that the ROE would decline by 2% but only used a beta of 1x, according to theory the stock would be almost 50% higher than where it is right now.
Equity capital for banks is extremely expensive right now and shareholders are correct to demand banks repurchase as much stock as possible.
“Equity capital for banks is extremely expensive…..”
Great risk demands more returns.
Fraud and misinformation on Wall St create risk.
No markets there.
The taxpayer gets the risk…………………
Wall St versus Main St!