Sheila Bair writes: As Chairman of the Federal Deposit Insurance Corporation from 2006 to 2011, I have front line experience with the problems and havoc that can ensue when large, interconnected financial institutions take excessive risks. I am committed to protecting American taxpayers from any future bailout of these so-called “too big to fail” institutions. The best way to do that is to ensure these institutions have adequate private investment to absorb the losses when they fail. That allows markets to work as they should – with private investors accepting the risks and taking the losses, rather than the “heads I win, tails the public loses” practices we saw during the financial crisis where some large banks and other “systemic” institutions were allowed to reap the profits of their risk taking, but turn to taxpayers for help when those risks turned sour.
Big financial institutions profit by relying primarily on borrowed money – instead of shareholder equity – to fund their loans and investments. Because the market views them as implicitly backed by the government, it is cheaper for them to fund themselves with debt instead of equity. Through high levels of leverage, executives are able to increase their returns on equity – and their bonuses which are frequently tied to shareholder returns. Prior to the financial crisis, some of our biggest Wall Street banks were borrowing an incredible $30 to $40 for every dollar of hard cash they had from shareholders.
Big financial organizations have strong financial incentives to increase leverage. This is why it is essential for global and U.S. regulators to take a firm line on the amount of borrowing they are allowed to do. U.S. banking regulators have already moved to limit big bank borrowing to less than $20 for each dollar of shareholder capital, and just last month proposed further borrowing limits for the largest U.S. banks that exceed the minimums set by international regulators. But behind the scenes, they’re facing intense resistance from many Wall Street banks, who are lobbying them to roll back and weaken their rules.
In the long run, better capitalized banks are in the interests of shareholders, creditors, and the public at large. Though tougher capital rules may impact returns on equity in the short-term, in the long-term, thick cushions of capital protect investors against unforeseen risks and position the bank to continue lending during downturns. Numerous studies have shown that well capitalized banks do a better job of lending through cycles. This helps guarantee sustainable profits for shareholders, and reduces the risk of default for creditors. Most importantly, well-capitalized banks are in a stronger position to lend during times of economic distress when the economy needs them the most.
