Banks, Private Benefits, and Social Benefits
If significant increases in capital ratios have only small consequences for the rates that banks charge their customers, why do banks generally feel compelled to operate in such a highly-leveraged fashion, in spite of the obvious risks this poses? And why do they deploy armies of lobbyists to fight against increases in their capital requirements? By way of contrast, it should be noted that non-financial firms tend to operate with much less leverage than financial firms, and indeed often appear willing to forego the tax (or other) benefits of debt finance altogether.
They proceed to argue that when one financial intermediary competes with another, the ability to use high leverage makes a large difference in market share and profits, even though it makes only a small difference in the ultimate cost to the the users of the intermediary’s services. The ability to achieve high leverage creates private competitive benefits that far exceed the social benefits.
Thanks to Simon Johnson for the pointer.
This strikes me as correct and also very important. Some implications.
1. Financialization of the economy (growth in financial intermediaries relative to nonfinancial firms) will generate a lot of private benefits, supported by intense lobbying, but very little social benefit. (In fact, when you take into account the tail risk that this creates, it is a huge social cost.)
2. Re-read Why We Have Freddie and Fannie in light of this thinking. Fannie and Freddie became as large as they did precisely because they had lower capital requirements than competing firms.
3. For that matter, re-read Not What They Had in Mind. You can appreciate why I put capital requirements at the heart of the narrative.
4. This analysis may affect one’s view of the value of the financial bailouts. I think that the authors would take the view that extremely rapid de-leveraging causes harm, by driving risk spreads above their long-run equilibrium values. But if the model is that the private benefits of leverage are enormous relative to the social benefits, then perhaps we would be better off today if more of the highly-leveraged institutions had failed. It is possible that the damage to risk spreads would have been short-lived, and that by now we would be enjoying the benefits of more efficient deployment of savings.