After the planned new €24 billion equity capital injections are completed, the surviving domestic Irish banks will be highly capitalized, with equity-to-assets ratios peaking at extremely high levels (above 20% except for BOI at 16%) and then declining (after projected losses) to still high levels (baseline 10.5%). For details, see this Irish Central Bank report. This puts Ireland in the vanguard of a new regulatory movement, across many countries, to impose substantially higher equity ratios on banks. There is strong and reasonably widespread support for this movement among academic economists and in financial regulatory bodies around the world.
Is Ireland an appropriate test case for this new regime of much higher equity ratios? Higher equity ratios provide a safety buffer for bank depositors and bondholders, but they also provide a safety buffer for bank management. Troubled banks can fall into the “zombie bank” trap in which management squanders new funds endlessly, in order to preserve established banking relationships with failing clients and/or to hide their pre-existing losses. Around the world, state-owned corporations are legendary for their ability to waste shareholder (taxpayer) funds. Will the presence of unusually large equity buffers tempt the managers of state-owned Irish banks toward wasteful and/or politically expedient behaviour?
I have two main points to make in this blog entry:
1. The enforced “over-capitalization” of Irish banks was the correct thing to do in the circumstances, but this new policy requires continuous monitoring. There will be numerous pressures to waste the “excess” capital — these pressures need to be resisted.
2. Ireland is now an important test case in the new international experiment with higher bank equity ratios. No one can predict all the effects.
There are some big potential benefits from imposing higher bank equity ratios. By decreasing the degree of leverage implicit in bank equity, higher ratios limit any future hyper-profitability of the financial services sector, both from the perspective of shareholders and senior management. This might possibly limit the incentives to engage in excessively risk strategies. Also, since higher ratios force banks’ assets to be smaller relative to any fixed equity amount, they might help to shrink the bloated size of this recently very troublesome sector. Most importantly, higher equity ratios lower the likelihood of bank distress, and thereby lower the big external diseconomies associated with it. These external diseconomies come both from network effects (one bank in distress can freeze the entire trading network) and too-big-to-fail problem (governments are forced to socialized private bank losses).
High equity ratios solve the too-big-to-fail problem in a roundabout way. Imposing high capital ratios effectively changes too-big-to-fail into very-unlikely-to-fail, since an over-capitalized bank should have a failure probability close to zero. Related to this, perhaps the strongest argument for high capital ratios is the empirical finding of a cross-sectional statistical relationship linking low capital ratios (in December 2007) to subsequent distress (2008 and after) across individual banks.
Of course there are some drawbacks to higher equity ratios. There are good reasons for believing that increased equity ratios will raise the cost of loan funds. Sensible proponents, like David Miles of the Bank of England, argue that the overall growth impact of this increase in bank funding cost will be relatively small. Miles estimates that increasing bank equity ratios from 6% to 20% will only put a drag of 1/6 of 1% on GDP growth per year, less than a tenth of the offsetting benefits. More extreme proponents like Admati et al. claim that there will be absolutely no increase in bank funding cost after netting out tax benefits (which are a cost to the exchequer). This purist view requires an old-fashioned belief in neoclassical finance theory.
The relevant tradeoffs are different for Ireland. A key motivation in the Irish case is to replace the government liability guarantee and the enormous ECB LOLR exposure to Irish bank debt with private sector bank funding. At a minimum, perhaps the greater safety provided by these high equity ratios might eventually help to end the slow steady drain of existing private sector funding of the banks. Another “advantage” (not from an Irish perspective) is that this bigger equity cushion improves the risk quality of existing ECB and Euro-area (French, German, etc.) financial institutions’ claims on the Irish banks. Also, the initially very high equity cushion (23% aggregate sector equity ratio) will partly be spent trying to solve the related liquidity problem of the banks, with forced selling of non-core assets at a loss in order to improve loan-to-deposit liquidity ratios.
Since they are now effectively state-owned, will Irish banks be tempted to waste their “excess” equity capital on management slack or political convenience? Special interest groups – mortgage holders, troubled Irish businesses with existing bank relationships, local and regional interests, unions, various business-related lobbyists – would all appreciate a piece of this potential €24 billion windfall. Eddie Hobbs has already earmarked the entire new capital infusion to be spent on helping out troubled mortgage holders:
“We have put in 24 billion euros, of the 70 billion that has gone in [to the banks], to deal with defaults on mortgages. We have tens of thousands of Irish families that are waiting for someone to come along, put them through this process, and relieve them of the debt.”
– Eddie Hobbs on the Marian Finucane Show on RTE radio 1st May 2011 (at minute:second 20:48).
That policy suggestion completely strips the banks of all their “excess” capital, and shows how easily it will be for banks to expend this new equity cushion.
 There are numerous permutations of the bank equity ratio using various definitions of the numerator and denominator; I am referring to Core Tier 1 equity to risk-weighted assets.