Optimal bank leverage David Miles Bank of England January 2010

Optimal bank leverage The title begs a question: optimal from whose point of view? Given tax breaks on debt financing (ie tax deductibility of interest payments but dividends paid from post tax income) then what is optimal from a companys point of view may not be overall optimal. The tax point is not entirely clear-cut because how dividends and interest payments are taxed at the personal level also matters. If banks also have a substantial part of debt liabilities insured (explicitly or implicitly) at terms that are subsidised they will hold too little capital. Both those factors will undermine MM – as is well understood.

Optimal bank balance sheets We certainly start from a position in which capital and liquidity have been allowed to fall to levels that are low relative to the past…. In middle of last century capital was about twice as high as it was on eve of crisis..100 years ago it was probably 3 times as great. It is not clear that assets were more risky 50 or 100 years ago….so effective capital levels have fallen very far. Bank liquidity has fallen even more relative to the past.

4 Banks long-run capital levels

5 Liquidity Ratio of the UK Banking Sector

Optimal Capital Even if we ignore the tax issues and assume that any state insurance of retail debt liabilities is absent (or priced correctly) there would still be a question about whether financing risky bank assets primarily with debt is optimal. One could argue that most existing bank assets should be funded by equity, not deposits that are seen as safe and liquid. The narrow banking view is really one end of a spectrum on where you should set capital requirements.

Optimal Capital Is it costly for banks to have much lower gearing – absent tax and under-priced deposit insurance? Note incentive / optimal contracts literature of Gale/Hellwig/Diamond. Asymmetric information, which is both a cause and consequence of delegating monitoring to banks, may make debt contracts natural – both between borrowers and the banks, and suppliers of finance to banks. A fixed debt contract is a more natural one when assets are hard to assess than one which makes returns to an investor depend on asset values.

Optimal Capital Financial intermediaries ….. monitor much information about their borrowers…. but typically do not directly announce the information………. The intermediary in this model …simply makes payments to depositors. We show that debt is the optimal contract between the intermediary and depositors. Diamond, RES, 1984 An interesting implication of the delegated monitoring model is that intermediary assets will be illiquid. The delegated monitoring model predicts well-diversified financial intermediaries with a capital structure which is mainly debt (deposits), with despite this high leverage, a low probability of default Diamond RES, 1984.

Optimal Capital I used to find this set of arguments persuasive – but now much less so. There may be efficiencies in having risky credit intermediated through highly leveraged banks. But also costs. The state may need to provide explicit or implicit insurance and those costs may not fall upon the banks. Diamond 1984 avoids this by assuming assets are so diversified that deposits become safe. But if retail debt liabilities of banks are insured this undermines the incentives of bank creditors to monitor bank management and, by withdrawing funds, to discipline the management.

Optimal Capital If providers of wholesale funds are not insured they may provide the discipline – but that may also generate wider costs if they withdraw funds and precipitate a generalised liquidity crisis. The microeconomic case for having large, highly levered banks making risky loans begins to unravel when system-wide contagion effects become important.

Optimal Capital Could most existing bank assets be funded largely by equity: banks become mutual funds? The Diamond/Hellwig results suggests that is not optimal. But Diamond result requires banks hold diversified assets, which removes the incentive problems between the bank and its funders The impact of forcing banks to become much more equity financed depends on the alternatives to bank lending to households and to non-financial companies.

Optimal Capital It is one thing to say that assessing the credit worthiness of a potential borrower is hard and quite another to say that banks have such a comparative advantage in doing this that to have them do less intermediation is very costly. It is very clear now that the monitoring of asset quality by banks in recent years was not done well. It is not self evident that when it is hard to assess the value of projects that a debt contract is the optimal form of finance. Most of the financing of the industrialisation of UK did not come via banks. Railways and canals were largely financed by companies issuing debt and equity.