Markets Don't Trust Banks, and They're Right

Markets Don't Trust Banks, and They're Right
The financial crisis should have led to fundamental change. It hasn’t happened.
 
by Mark Whitehouse       Bloomberg.com      May 30, 2017, 2:00 AM EDT
 
Almost a decade after a crisis that nearly brought down the global financial system, markets still aren’t showing much confidence in banks. It’s a troubling phenomenon that U.S. and European leaders ignore at their peril.

It’s understandable that, after years of wrangling and thousands of pages of new rules, regulators might want to consider their mission accomplished. They have changed the way they supervise the system, reorganized derivatives markets, subjected banks to regular stress tests and instituted myriad new reporting requirements. To bolster banks’ loss-absorbing capacity, they have required hundreds of billions of dollars in added capital.  

Yet, as former U.S. Treasury Secretary Larry Summers has taken to pointing out, markets don’t appear to believe that banks are much healthier. This is evident in how they value equity -- that is, the amount by which a bank says its assets exceed its liabilities. Back in the early 2000s, investors often paid $2 or more for each dollar in book equity, a sign that they trusted banks’ accounting and expected to reap significant profits. Now, though, even after the mini-boom following Donald Trump’s election, they’re valuing the largest five U.S. banks at about $1.16 per dollar of book equity, and the top five European banks even less.


What gives? Declining profitability is one explanation. With forecasts of long-term economic growth much lower than they were in 2007, investors can’t expect banks to make as much money. Also, new regulations require a lot more employees to gather data, assess risks and imagine worst-case scenarios. Although one could argue that banks should always have been doing these things, the added cost means there’s less money left over for shareholders.

Smaller returns, though, can’t explain the whole gap. Trust matters, too. After a crisis in which supposedly well-capitalized institutions suddenly found themselves in distress, it stands to reason that investors wouldn’t have much faith in the numbers banks produce -- particularly given how opaque the accounting tends to be. Investors might also have come to recognize what Mervyn King, the former head of the Bank of England, calls “radical uncertainty”: It’s just impossible to foresee and assign probabilities to all the things that can go wrong with a bank.

What to do? Simplifying regulation could help. A lot of the most burdensome rules arose because banks have been so resistant to the elegant approach of sharply increasing loss-absorbing equity. Even with all they’ve raised in recent years, the largest banks’ equity amounts to about 6 percent of total assets on average (measured according to international accounting standards). If they had closer to 20 percent, enough to weather an unforeseeable disaster and still be well-capitalized, they would inspire greater confidence and require less supervision. By making shareholders more fully responsible for losses, the added equity might also create an incentive to unlock value by dividing the largest, most complex banks into more manageable and understandable pieces.
 

Equity alone, though, probably isn’t enough. Any institution that depends on short-term borrowing to make long-term investments -- be it a bank, a hedge fund or a money-market fund -- can become the target of a panic, with economy-wide repercussions. Only a much more radical restructuring of the financial system can address this weakness. King, for example, has proposed a system in which the central bank would effectively guarantee all short-term debt and stringently limit the kinds of investments that could be financed with it. Together with higher equity requirements, such an approach could allow most other regulations to be scrapped.
Markets are sending a warning: The fundamental change that the crisis called for has not happened. The battle to achieve incremental change has left everyone fatigued without fixing a flawed system. It may take another big disaster to drive that lesson home.