Dividend Lost

By Simon Johnson
Four types of people were directly affected by the Federal Reserve’s decision at the end of last week to allow major banks to increase their dividends and to buy back shares.  Three of these groups – bankers, bank shareholders, and government officials – were somewhere between happy and delighted.  The four group, US taxpayers, should be much more worried (see also this cautionary letter to the Financial Times by top finance academics).
The bankers’ reaction is obvious.  They are officially released from the financial hospital ward that was set up for them in 2008.  No matter that this was a very comfortable place with few conditions relative to any other bailout in recent US or world history – there were still restrictions on what banks could do and, naturally, bank executives chafed at these constraints.
In particular, banks were required to build up the equity in their business – insolvency is avoided, after all, while there is positive equity in a business.  When shareholder equity is exhausted, creditors face losses.
You might think that the people who run banks have an incentive to keep equity at a high level – providing a cushion against future losses and effectively protecting creditors.  And banking did operate in this fashion back when government was much smaller and effectively unable to save large financial institutions.
But that was in the nineteenth century – when banks had capital levels in the range of 30-50 percent (and functioned fine at that level).  In the twentieth century, the equity in banking has tended to decline relative to debt; this is what it means when people say leverage has gone up.
A thinly capitalized bank is like buying a house with very little money down and a mortgage for 98 percent of the purchase price (and such levels of leverage, up to 50:1, were common in the run-up to 2008).  If the house price goes up, you have done very well relative to your initial investment.   Of course, if the house price goes down, you are under water faster when there is less equity in the business – and creditors are more likely to face losses (depending on your cash flow and broader incentives to default.)
The Fed’s decision on dividends effectively lets the banks pay out shareholder equity, making the banks more highly leveraged.  Bank executives and other key personnel are paid on a “return on equity” basis, so this increases their upside, i.e., what they will make as long as the economy and their sector does well.  (Look at Figure 2 on p.15 of the just updated paper by Admati, DeMarzo, Hellwig, and Pfleiderer; their analysis has become central to the debate.)
Up to a point, this also makes bank shareholders happy – their equity (left in the business) will have more leverage and therefore also higher upside.  The shareholders should, of course, worry about the bank executives taking on more leverage than is optimal from an owners’ point of view, but it really does not seem that even the more articulate shareholder groups are paying sufficient attention, e.g., to who supervises risk management at the board level.
And if the bank is presumed “too important to fail”, there is considerable downside protection for bankers and their shareholders – as well as for the creditors.
One group that should be more concerned about this arrangement is those government officials who are directly charged with ensuring financial system stability and who are well aware of the externalities involved in bank capital decisions.  Any individual bank will want to keep its equity levels low – because its executives and owners are not worried about system-wide spillover costs, i.e., what happens to other banks when any one bank fails.
The Fed was naturally worried about bank equity during the crisis – most officials were unhappy, for example, when banks paid big bonuses in 2008 and 2009; higher wage compensation means lower bank profits and hence less shareholder equity (before the decision on whether this should be retained or paid out).
The Fed has also agreed to the higher capital requirements of Basel III (although these are not enough).  And, by all accounts, it will impose some form of “capital surcharge” on the country’s largest banks (the details are not yet announced, but these are also unlikely to prove sufficient).  The term “surcharge” is a misnomer; this is not any kind of charge or tax, but really just the requirement that big banks finance themselves more with equity relative to debt – because of the dramatic ways in which they can damage the system.
Yet the impression conveyed by Fed officials last week was more one of triumph than the wary caution that one would expect.  Our nations’ leading practical thinkers on this issue have really convinced themselves that bank equity levels now are more than fine – so they can be reduced by payouts to shareholders.  This is despite the fact that the “stress tests” just used to this purpose are highly suspect because they were run by the banks themselves and the results will not be published in any detailed way; this is disturbingly similar to the European bank stress tests of summer 2010, which were a complete disaster (see Section V of the Fed’s technical paper, pp.18-19).
Top Fed officials really seem to think:

1. The events of 2007-8 were rare and cannot happen again anytime soon.  “Do you really think supervisors could make the same mistake again?” is one refrain.  This ignores completely all dimensions of political economy (the power of banks) and cognitive capture (the power of ideas put forward by bankers).
2. The Fed made money on their various and extensive interventions.  This is true, very narrowly defined, but such calculations are – as they should know – highly suspect because they are not risk adjusted.  Ask yourself this: if the Fed and other government officials were to repeat this kind of support for the financial system 10 or 20 times, how often would it go well?
3. There are no other first-order costs worth considering.  This is outrageous and unacceptable – what about more than 8 million jobs lost and a deep recession that will end up increasing net federal government debt held by the private sector by around 40 percentage points of GDP?

The US taxpayer has a much greater burden of debt as direct result of lost tax revenues due to the deep recession; the Bush stimulus of 2008 and the Obama stimulus of 2009 had little effect relative to the loss of tax revenue, 2008-11.
But who in modern American political life really cares about the taxpayer?  Apparently not the Federal Reserve.
Perhaps just Senator Sherrod Brown (D., OH), a member of the Senate Banking Committee, who said on Wednesday,
“I’m concerned by both the process and the outcome of the Fed’s decision. How did the Fed conduct these tests, and how did each tested bank fare? What effects will this decision have on the current financial stability of these banks and their preparations to meet enhanced capital requirements in the coming years?  And why, in a time of slow economic growth, are banks increasing leverage rather than lending?
“Given the success of the first set of U.S. stress tests, and the failure of the more opaque European stress tests, the Fed should have been as open and transparent as possible with the American public.  Unfortunately, at this point its actions have raised more questions than they have answered.”
An edited version of this post appeared this morning on the NYT.com’s Economix blog; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.