The bad, the good and the ugly
DELEVERAGING, history tells us (via McKinsey research) is set to be the main economic trend for years to come. But a new paper by Anat Admati and her co-authors shows (amongst lots of other things) that the term is pretty unhelpful. The paper contains more interesting evidence on the bank capital debate, and as a part of that argument shows that deleveraging could mean either smaller balance sheets or larger ones. Here’s a diagram:
The first way to cut leverage—the ratio of assets to equity—is to reduce the amount of debt a household, firm, bank or government holds. In order to balance the books, assets must be reduced too. If you believe that assets support some kind of real economic activity which you care about, this is bad deleveraging. But balance sheets can be bolstered without cuts in activity too, as the diagram makes clear: with more equity a balance sheet of the same size has lower leverage. And the books can be made both larger and stronger at the same time, if equity grows proportionately more than debt. This would be good deleveraging. Whichever the type, good or bad, lower leverage should reduce risk: equity buffers are bigger and the likelihood of default is lower. The benefit should be lower borrowing costs. But a new tranche of data for British firms released today shows that this is not always the case. The problem is set out in three charts that use this, and other data, below. The first shows that, since mid 2008, firms have cut more debt than they have raised equity. Balance sheets are smaller and activity is lower, suggesting British firms are stuck in one of Richard Koo’s balance sheet recessions. Adding to the misery, firms’ newly beautified balance sheets have not led to cheaper borrowing. In fact (second chart) rates on new borrowing have been increasing, despite a fresh round of quantitative easing. The likely reason (third chart) is that banks’ own debt costs—as proxied by CDS premia—are on the rise again. That makes lending more expensive to do, and so banks—themselves trying to deleverage—pass the cost on to their customers. So British firms are experiencing ugly deleveraging: all the pain with none of the gain.