Supporters of Capitalism Should Read This

Andrew Smithers is the chairman and founder of Smithers & Co., an economic consultancy well known for its international asset allocation advice. He is a regular financial commentator and columnist and author of several academic publications. His most recent book is titled Wall Street Revalued: Imperfect Markets and Inept Central Bankers.

Bankers have brought capitalism into disrepute. To their traditional enemies on the left, they have added those who favor free markets. Despite the remarkable achievement of uniting such a broad spectrum of political opponents, bankers clearly expect to avoid retribution for their misdeeds. Supporters of capitalism, who want its benefits preserved, call for large increases in banks' equity capital. U.S. banks have responded by buying back their equity. The left denounce the outrageous pay levels, and bankers respond by awarding themselves huge additional bonuses.

These actions suggest that bankers, as a group, are not unduly sensitive people. But it is nonetheless incredible that they do not realize that large increases in their equity will be part of the new regulations. Their motive in buying back part of their already inadequate equity calls for examination.

An examination of equity
Taxpayers guarantee banks' debts. No industry in this happy position needs any equity unless it is required by law. The guarantee is therefore a subsidy, because capital is a cost, and equity capital is its most expensive form. Supporters of capitalism favor unrestricted competition and abhor subsidies. They are therefore natural opponents of the fact that taxpayers subsidize banks. There are two possible solutions: One is to end the guarantee, and the other is to increase the amount of equity required by regulation until the increased cost offsets the subsidy. Only the second approach is a practical possibility.

Faced with the question of how much equity ratios need to rise, a number of different approaches are possible. One is to look back in history to see how much equity banks needed before the subsidies were introduced. This suggests that current equity ratios need to triple from around 8% or so, to 25%, to 30%. (Deutsche Bank (NYSE: DB  ) had an equity ratio of 30% in 1929 and still needed taxpayers' support a few years later.) A similar answer is suggested by the data in a recent paper published by the Bank of England. This shows that U.K. banks used to have similar returns on equity to other industries, but that more recently, their returns have been around three times the general level. At the same time, their equity ratios have collapsed.

When gratitude is unwelcome
Bankers don't want to lose their subsidies, so they don't want new regulations which demand large increases in equity ratios. They are also acutely aware that the debate is more about politics than economics and that they have great political clout. For many years, banks and bankers have been the largest beneficiaries of the sharply growing gap between average incomes and those at the top. They have been large contributors to the coffers of political parties and individual politicians. As a result, they have access to legislators, who are no doubt anxious not to cut off the future flow of finance from this source. Both bankers and politicians are no doubt grateful people and gratitude has been well defined by noted French author Francois La Rochefoucauld as, "a lively expectation of future favours." The confidence shown in bankers' behaviour seems to reflect the pertinence of this dictum.

But such gratitude becomes even more powerful when supported by propaganda, and this probably explains why banks have been reducing their equity capital at a time when they clearly need to be massively enhanced. If they added rather than subtracted from their equity in preparation for the new regulations, they would be tacitly agreeing to the validity of the reformers' case. By appearing to believe that their current ratios are unnecessarily high, they hope to make a modest increase, such as 20% to 30%, seem bold and sufficient.

A lively expectation
The bankers' tactics have unpleasant consequences both for the economy and the stock market. The more successful they are at keeping equity ratios low and their subsidy high, the sooner and larger the next financial crisis will be. The impact on the stock market is to make it more volatile. Buying today pushes up share prices and issuing them tomorrow will pull them down. This threat of volatility helps the bankers. The more equity they buy back today, the more equity they'll need to raise later -- increasing the chances that this future equity raise will cause the next crash on the stock market and the next financial crisis.

What are your thoughts on current equity buybacks and the prospect of future regulations in banking? Sound off in the comments section below.

Andrew Smithers does not own shares of any of the companies mentioned. The Motley Fool has a disclosure policy.


Read/Post Comments (3) | Recommend This Article (26)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 22, 2010, at 8:26 AM, MPov wrote:

    I thought that banks' debts were guaranteed by FDIC insurance, which the banks pay for. The recent bailout involved lots of taxpayer dollars to help banks stay solvent, but that isn't the ordinary course.

  • Report this Comment On April 22, 2010, at 3:37 PM, TMFHousel wrote:

    MPov,

    But who backs the FDIC if it runs out of cash? The Treasury, and hence taxpayers. If it weren't for this backing, FDIC insurance would cost multiple times what it now does.

  • Report this Comment On January 27, 2011, at 8:24 PM, TMFAleph1 wrote:

    @MPov

    Bank deposits are guaranteed by the FDIC. Bank debt is another matter altogether.

    Alex Dumortier

Add your comment.

DocumentId: 1159606, ~/Articles/ArticleHandler.aspx, 4/18/2014 9:55:56 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement