Stanford B-school prof Anat Admati has a piece in DealBook arguing that banks should have much higher equity cushions and that you should ignore banks’ complaints that those cushions will lower ROEs.
We love this article only because she says something that should be engraved on the foreheads of anyone who wants to comment on bank equity:
Bankers use confusing language that presents equity, or “capital,” as a pile of money that banks must “hold in reserve” or “set aside” passively. This confuses capital requirements, which concern funding only, with liquidity or reserve requirements, which concern how funds are invested. It is you, investors, who hold banks’ equity or capital, not the banks that issued it.
Agreed! Except that we usually see journalists saying that banks will have to “hold capital.” As far as we can tell banks mostly know what capital is.
In general the column is a summary and popularization of a longer paper comprehensively examining and rejecting various arguments against increasing bank equity requirements. Admati makes the basic Modigliani-Miller point that considering return on equity while ignoring capital-structure risk is a mistake:
Since investors must be compensated for bearing risk, higher leverage increases the required, or expected, return on equity. To judge whether a manager has created value, one cannot simply look at the return on equity; one must adjust for risk. A bank manager can attempt to reach a “target return on equity” by taking on more risk and by using more leverage, but this, in and of itself, does not create value. It does, however, increase fragility and systemic risk.
But, of course, equity holders like the increased leverage because it gives them option value, as they get all the upside while creditors and/or the government bear the downside. That said, equity holders too might prefer somewhat reduced risk of being written down to zero or almost zero a la Lehman and Bear.
We ran a toy model using 10 big banks of various flavors (JPM, BAC, C, WFC, USB, PNC, RF, STI, GS, MS) and got this pile of nothing:
So, erm, yes. Lots of noise here but this suggests that maybe even shareholders have concerns other than ROE.
Beware of Banks’ Flawed Focus on Return on Equity [DealBook]
Not good. First, if you want to say that investors like high ROE, wouldn’t you want to regress some measure of valuation (M/B, P/E) on ROE?u00a0nnSecond, “But, of course,u00a0equityu00a0holders like the increased leverage because it gives them option value, as they get all the upside while creditors and/or the government bear the downside.” If equity holders want option value, they can buy options. Options aren’t somehow magically more valuable than other claims. If I’m an equity holder who can buy both equity and options, presumably I’m indifferent between the two on the margin. So why would I be better off if you make my equity look more like an out of the money call?
Peanut M&Ms > Miller-Modigliani
ROE is the least of my concerns.u00a0 What concerns me is WWRMC.
Re-posting dealbook articles is the new not killing it.
it is a she not a he
I just think of Bess and WACC
the other possiblity is that “accounting ROE” probablly isn’t such a great measure…who ever heard of banks taking any extraordinary profits/losses (thats sarcasm, you need to heavily adjust ROE). also you should regress it against P/B.
Implicit here is the assumption that the bank gets to lever up more cheaply than you can. Is that consistent? It seems reasonable that banks get better borrowing terms than most investors.
this guy really doesn’t get it…does he?nYes you are very smart…..what’s your point sweety?
sweetie
Still using ‘toy models’ on a gossip/humor blog, I see. Lloyd would be so proud. nn
I would hit that
what?
Sure, but that’s separate from saying that they like it “because it gives them option value.”u00a0
Ignoring for a moment the sad fact that most bankers (unlike DB posters) are idiots, a higher equity requirement means lower leverage. Lower leverage means:na. Lower profitsnb. Taking more risk to mantain profitsnc. Largeru00a0Gross Interest Margins inorder to maintain profits, which means higher interest rates to borrowersnd ?n
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