giovedì 11 novembre 2010

Higher capital requirements: possible reforms and hidden costs

Recently a letter signed by some of the most prominent financial economists was published in Financial Times, arguing in favor of tighter capital requirements rules for financial intermediaries.

While I agree with the general message that capital requirements are a viable tool to reduce the probability of future systemic crises like the current one, I would like to rise some doubts.
The letter highlights two important points:

1) "Some claim that requiring more equity lowers the banks’ return on equity and increases their overall funding costs. This claim reflects a basic fallacy. Using more equity changes how risk and reward are divided between equity holders and debt holders, but does not by itself affect funding costs."

2) "Tax codes that provide advantages to debt financing over equity encourage banks to borrow too much. It is paradoxical to subsidize debt that generates systemic risk and then regulate to try to limit debt. Debt and equity should at least compete on even terms."

Since point 2) is obviously right, why does this letter propose to increase capital requirements, which is equivalent to put constraints to financial leverage of intermediaries, while at the same time arguing in favor of neutral taxation of financial sources? If a proposal was seriously enacted to adopt a new corporate income tax that does not exempt interests, like the ACE or CBIT taxes much discussed in the economic literature, then high leverage would not be subsidized anymore. Decisions about the degree of leverage formed under free markets would therefore be close to optimum, so why bother having costly controls and regulations?

The first point, in my view, is partly misleading. While it is true that a large financial intermediary will not suffer additional costs from higher capital requirements, since it will simply shift debt with equity and this will lower its financial riskiness (thus lowering, not increasing, its costs of funding), this is not necessary true for a small intermediary.
Small firms are less transparent to investors, and they can face borrowing constraints in the equity market. This happens because under informational asymmetry investors cannot tell the real productivity of such firms, and so they prefer to lend funds as fixed-interest debt in order to reduce risks. High capital requirements may therefore increase funding costs for small intermediaries, which could even be very profitable and productive: just think about venture capitals and highly innovative firms, or small lending firms working in limited territorial areas but having a better knowledge of the specificities of their customers, thus obtaining better credit scorings than large lenders.

These remarks are not intended to subtract from the proposal of stronger capital requirements. What I would like to see is a more radical and long-term oriented discussion about the international financial system, that should include both:

- a reform of corporate taxation toward more neutral tax tools, namely a tax that either does not allow for interest allowance, or that includes "normal" equity income as a deductible cost;

- and an assessment of distortionary effects on smaller intermediaries brought by strong capital requirements. We do not need Too-Big-Too-Fail banks anymore, and if capital requirements favor large intermediaries, this is a cost of such policy we should better estimate. Large banks, being the ones that "cannot be left to fail", bring hidden costs in terms of an implicit public guarantee against bankruptcy, which is not necessarily extended to small intermediaries. Favoring more the former against the latter may prove detrimental both to the overall efficiency of financial markets intermediation, and to the very aim of capital requirements, namely to curb future systemic risks.

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