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The Bankers' New Clothes - What's Wrong with Banking and What To Do About It Watch

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    Has anyone read this book? I am reading it at the moment and finding it fascinating. It is written by a Professor of Finance and Economics at Stanford business school and another economics professor, and has some impressive endorements (have a look at the amazon link below).

    It argues that the fundamental problem with finance is too much bank leverage, and that equity (capital) requirements should be in the region of 25-30%. It spends a lot of time debunking the arguments of bankers that this would have adverse impacts on lending and the economy (these arguments are alleged articles of the 'bankers new clothes'). It says there is widespread confusion among commentators and politicians between a capital requirement (on the liabilities side of the balance sheet) and a reserve requirement (on the assets side). The latter will affect lending, the former will not (they argue). The narrative of capital being "set aside", for example, is highly misleading, given capital requirements are a condition on how funds are raised and not what you can do with them.

    They say that the reason banks are so highly leveraged relative to most companies (equity ratios of up to 10% as opposed to 50-100% in conventional companies) is essentially because they have an implicit guarantee of a government bailout. This also makes their debt cheap. The high leverage makes crises more likely, so they compare this to subsidising a chemicals company to pollute a river.

    It says we could implement this very easily by, for example, forcing banks to retain earnings until they hit the required equity ratio.

    I would be very interested to hear the thoughts of people on this forum about this. The book has certainly changed how I think about finance and bank regulation.


    http://www.amazon.co.uk/The-Bankers-...rs+new+clothes
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    (Original post by Budgie)
    I would be very interested to hear the thoughts of people on this forum about this. The book has certainly changed how I think about finance and bank regulation.
    I'm curious as to what you thought about financial regulation before.

    A basic grasp of what leverage is, and what it entails for the potential for bankruptcy will tell you that it should be monitored and regulated for systematically important institutions.

    But leverage is just one piece of a bigger puzzle, and the largest banks are systematically important regardless of how much leverage they use. Of course, the significance of being systematically important increases with leverage use, but the point is that capping leverage isn't especially likely to make these institutions any less important in terms of the effects of a hypothetical bankruptcy, regardless of the probability of that event. Regulators need to distinguish importance from the probability of that importance being a problem. Fixing leverage will only help the latter.

    Capping leverage won't stop you racking up losses either (and note that high leverage is not always a cause of losses, it can be a symptom and effect of them too. Actually, I suppose there's a shaky case for arguing that regulators should allow for high leverage when borrowing is necessary to sustain the business.), especially if regulation is implemented poorly, as it has been in the past.

    If your aim is to make banks safer, capital requirements and risk modelling should be top of your agenda. And, though this is speculation on my part, I think there could well be distortionary effects from implementing poor capital requirements, even if these distortions don't affect lending.
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    (Original post by MinorityInterest)
    I'm curious as to what you thought about financial regulation before.

    A basic grasp of what leverage is, and what it entails for the potential for bankruptcy will tell you that it should be monitored and regulated for systematically important institutions.
    Yes, but these proposals are radical. Before, I had (probably because of its repetition by bankers) bought the claim that lower leverage meant less lending for the economy. Having read (most of) the book, I am now convinced that that is not the case. That realisation is game-changing, as suddenly you can justify equity requirements as high as 25-30%, instead of the, say, 4% recommended by Vickers. Your tone is a bit harsh - I'm not the only one who views these proposals as radical and the book as persuasive and perspective changing; check out the 'inside flap' comments on Amazon or see, for example Martin Wolf's review in the FT (behind paywall unfortunately) - http://www.ft.com/cms/s/2/39c38b74-7...44feab49a.html .

    (Original post by Martin Wolf)
    If you think that running banks with so little loss-absorbing equity is crazy, you are right. This book shows why you are right. It is the most important to emerge from the crisis.
    (Original post by MinorityInterest)
    But leverage is just one piece of a bigger puzzle, and the largest banks are systematically important regardless of how much leverage they use.
    The argument is not that leverage is what makes the banks systemically important, it is that it makes them more likely to need a bailout. They are systemically important, and that means the state will bail them out in a crisis. If there is sufficient equity, bailouts will be far less likely to be needed in a crisis. The banks will remain systemically important, but it will be less risky from the point of view of society as the holders of equity will take (more of) the hit in a crunch. EDIT: Sorry, I realise in my first post that I did write that the leverage 'causes' the systemic risk; I should have written 'makes crises more likely' and have edited the post accordingly.


    (Original post by MinorityInterest)
    Capping leverage won't stop you racking up losses either (and note that high leverage is not always a cause of losses, it can be a symptom and effect of them too.
    The aim here is not to prevent losses, its to make taxpayer support less likely in the event of large losses. Large losses are fine if the bank has sufficient equity to take the hit. The relation between profit and leverage is quite weak: profit =/= return on equity. Leverage improves ROE and increases the chance of a bailout being needed for a given level of profit/loss.

    (Original post by MinorityInterest)
    Actually, I suppose there's a shaky case for arguing that regulators should allow for high leverage when borrowing is necessary to sustain the business.), especially if regulation is implemented poorly, as it has been in the past.
    Far better would be to force them to issue more equity in such a scenario. If it can't issue equity at any price, then it is insolvent anyway and in need of a bailout.

    (Original post by MinorityInterest)
    If your aim is to make banks safer, capital requirements and risk modelling should be top of your agenda. And, though this is speculation on my part, I think there could well be distortionary effects from implementing poor capital requirements, even if these distortions don't affect lending.
    I think the aim is just to stop taxpayers bearing the burden in crises, while banks profit from an implicit subsidy on their debt in the good times. If the authors are right, high equity requirements make the taxpayer a lot safer, crises less likely, and come at little if any cost to society.

    It's hard to imagine that the speculative distortions you suggest are more than the distortion of the implicit taxpayer guarantee that causes banks to choose to be so highly leveraged. Regular companies in regular industries don't operate at anything like the level of leverage of banks. We should be suspicious first and foremost of banks being so out of line with the norm, and the very clear risks of that.
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    (Original post by Budgie)
    Yes, but these proposals are radical. Before, I had (probably because of its repetition by bankers) bought the claim that lower leverage meant less lending for the economy. Having read (most of) the book, I am now convinced that that is not the case. That realisation is game-changing, as suddenly you can justify equity requirements as high as 25-30%, instead of the, say, 4% recommended by Vickers. Your tone is a bit harsh - I'm not the only one who views these proposals as radical and the book as persuasive and perspective changing; check out the 'inside flap' comments on Amazon or see, for example Martin Wolf's review in the FT (behind paywall unfortunately) - http://www.ft.com/cms/s/2/39c38b74-7...44feab49a.html .
    Equity requirement for what sort of assets though? All assets (incl. notional amounts of various instruments)? That's a bit too harsh, I think, and I'm not sure that could be justified. And what sort of equity?

    I don't want to get bogged down in this, but I'll posit that breaking down a 30% equity requirement between different asset types, risk-weighting them and then division between tiers of equity would make the proposal less radical, though certainly more radical than some other proposals.

    (Sorry if I sounded harsh, it was more curiosity; to me, understanding leverage implies that you'd be cautious of it. Though I'm not sure quoting Wolf there is really a benefit to your argument, his comment is there to sell the book as much as endorse the contents of it.)

    (Original post by Budgie)
    The aim here is not to prevent losses, its to make taxpayer support less likely in the event of large losses. Large losses are fine if the bank has sufficient equity to take the hit. The relation between profit and leverage is quite weak: profit =/= return on equity. Leverage improves ROE and increases the chance of a bailout being needed for a given level of profit/loss.
    I'm aware of this. My point was more that even the strictest cap on leverage can't rule out the prospect of losses that would require a government intervention. Also, leverage can increase profit (yes it affects ROE, but profit too), consider investing $10 equity in a project yielding 10%, you get $1 profit. Borrow $90, add it to the equity and invest in the project, you'll get $100, you owe $90 (+some interest, let's say it's negligible , but you'll get $10 profit instead of $1. Both your ROE and absolute profit has increased; essentially, leverage allows you to expand your opportunity set.


    (Original post by Budgie)
    Far better would be to force them to issue more equity in such a scenario. If it can't issue equity at any price, then it is insolvent anyway and in need of a bailout.
    Equity is generally more expensive to raise than debt. In such a case it would be very inefficient to issue common equity, and unless there was considerable faith in your firm I'd say it'd be inefficient to raise any equity.

    (Original post by Budgie)
    I think the aim is just to stop taxpayers bearing the burden in crises, while banks profit from an implicit subsidy on their debt in the good times. If the authors are right, high equity requirements make the taxpayer a lot safer, crises less likely, and come at little if any cost to society.

    It's hard to imagine that the speculative distortions you suggest are more than the distortion of the implicit taxpayer guarantee that causes banks to choose to be so highly leveraged. Regular companies in regular industries don't operate at anything like the level of leverage of banks. We should be suspicious first and foremost of banks being so out of line with the norm, and the very clear risks of that.
    Yes you're correct, that aim is somewhat implicit in what I wrote. And I don't think there's much of a doubt that from the general gloss of the book I've got that the authors are right about the need to require a greater amount of equity (ignoring specifics, generalised statement here).

    I don't think the implicit guarantee story is sufficient to explain why leverage was used for the simple reason that it treats bankers as overly risk-averse when I think it's clear that when people think they are right, they will want to bet big, and this means using leverage. I think the second issue is that it's very easy to see and understand that there was a guarantee in hindsight. But how obvious was it before the crash that some firms would be saved? Third, I don't think we should discount why leverage was used as a cause of using it. Do you use leverage because you'll get bailed out? No, you need something to invest in too, the market for synthetic CDOs and the like provided this. Don't just look at the firms, look at the market the lost money in.

    I probably wasn't explicit about the sort of distortions I had in mind. Poorly thought out capital requirements could lead to more of what we've already seen. You'll end up with opaque institutions who skirt around the rules. This is why I think you need to be more specific when you talk about equity requirements, the solution is more sophisticated than that.

    Finally, banks aren't like normal companies. They operate in a fundamentally different way (especially modern banks, less so I suppose with 3-6-3 banking), and are treated in a different way by accounting measures because of it. I find that drawing such comparisons is pointless.
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    (Original post by MinorityInterest)
    Equity requirement for what sort of assets though? All assets (incl. notional amounts of various instruments)? That's a bit too harsh, I think, and I'm not sure that could be justified. And what sort of equity?
    Two things...first, the purpose of the original post was about the book, if you haven't read the book then this all seems rather pointless. Second, your example about the use of leverage seems wrong. Your example uses two different projects. The right way to frame it is:

    You have one project in which you can invest $100, ROC is 10%. If you use $100 equity, EBIT is $10, ROE is 10%. If you have $10 equity, EBIT is $10, but your ROE is 100%...that is it.

    I don't really understand your point in context either, but clearly better capitalized firms can sustain larger losses with more equity (which I think was the point)...either way, I am planning on reading the book and it looks good.
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    (Original post by webuffett)
    Two things...first, the purpose of the original post was about the book, if you haven't read the book then this all seems rather pointless. Second, your example about the use of leverage seems wrong. Your example uses two different projects. The right way to frame it is:

    You have one project in which you can invest $100, ROC is 10%. If you use $100 equity, EBIT is $10, ROE is 10%. If you have $10 equity, EBIT is $10, but your ROE is 100%...that is it.

    I don't really understand your point in context either, but clearly better capitalized firms can sustain larger losses with more equity (which I think was the point)...either way, I am planning on reading the book and it looks good.
    Admittedly, much of the discussion is pointless without the book. But I'm working of what OP has summarised and it seems fair to say that he intended his summary to provide ample discussion material. This isn't a book club.

    Second, the leverage example is fine. The prospect is different and that's the entire point, it's a prospect you couldn't afford prior to leverage and it generates more profit. When you buy a stock with $10 of your own cash and it appreciates 10%, you've made a dollar, leverage your $10 to $20 and you'll make $2 minus interest. If you think that's wrong, point out the flaw. Leverage is not just used to increase ROE. When you mortgage your house you're doing a similar thing, expanding your opportunity set; appreciation of the property allows you make profit you didn't have access to before. Hence the attractiveness of large mortgages to first-time buyers with minimal equity. [EDIT: your example compares two different agents, one with $100 and one $10 dollars, clearly, faced with the same prospect they'll make the same amount if the $10 guy leverages himself to $100, but notice what happens if you compare the $10 guy pre and post leverage, he makes 10% on $10 without, 10% on $100 with].

    I suppose my underlying point is this: OP has either drastically oversimplified the story, or there's something missing in the content of the book; requiring x% equity is not an adequate solution.
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    (Original post by MinorityInterest)
    Admittedly, much of the discussion is pointless without the book. But I'm working of what OP has summarised and it seems fair to say that he intended his summary to provide ample discussion material. This isn't a book club.

    Second, the leverage example is fine. The prospect is different and that's the entire point, it's a prospect you couldn't afford prior to leverage and it generates more profit. When you buy a stock with $10 of your own cash and it appreciates 10%, you've made a dollar, leverage your $10 to $20 and you'll make $2 minus interest. If you think that's wrong, point out the flaw. Leverage is not just used to increase ROE. When you mortgage your house you're doing a similar thing, expanding your opportunity set; appreciation of the property allows you make profit you didn't have access to before. Hence the attractiveness of large mortgages to first-time buyers with minimal equity. [EDIT: your example compares two different agents, one with $100 and one $10 dollars, clearly, faced with the same prospect they'll make the same amount if the $10 guy leverages himself to $100, but notice what happens if you compare the $10 guy pre and post leverage, he makes 10% on $10 without, 10% on $100 with].

    I suppose my underlying point is this: OP has either drastically oversimplified the story, or there's something missing in the content of the book; requiring x% equity is not an adequate solution.
    err leverage isnt some sort of magical "increase profits without increasing risk" tool. your required return (=risk) increases with leverage.

    come on, finance 101 here
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    (Original post by Teenage Pirate)
    err leverage isnt some sort of magical "increase profits without increasing risk" tool. your required return (=risk) increases with leverage.

    come on, finance 101 here
    I didn't say that risk was unchanged at all. I'm merely demonstrating that leverage can increase profits (with the obvious corollary that it can increase losses too), that was all.

    Come on, comprehension 101 here.
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    (Original post by MinorityInterest)
    Admittedly, much of the discussion is pointless without the book. But I'm working of what OP has summarised and it seems fair to say that he intended his summary to provide ample discussion material. This isn't a book club.

    Second, the leverage example is fine. The prospect is different and that's the entire point, it's a prospect you couldn't afford prior to leverage and it generates more profit. When you buy a stock with $10 of your own cash and it appreciates 10%, you've made a dollar, leverage your $10 to $20 and you'll make $2 minus interest. If you think that's wrong, point out the flaw. Leverage is not just used to increase ROE. When you mortgage your house you're doing a similar thing, expanding your opportunity set; appreciation of the property allows you make profit you didn't have access to before. Hence the attractiveness of large mortgages to first-time buyers with minimal equity. [EDIT: your example compares two different agents, one with $100 and one $10 dollars, clearly, faced with the same prospect they'll make the same amount if the $10 guy leverages himself to $100, but notice what happens if you compare the $10 guy pre and post leverage, he makes 10% on $10 without, 10% on $100 with].

    I suppose my underlying point is this: OP has either drastically oversimplified the story, or there's something missing in the content of the book; requiring x% equity is not an adequate solution.
    the flaw is that profit hasn't changed...your example doesn't work because the stock that was at $10 is now magically at $20 for the second example. for the mortgage example, i don't get your point. As I think is stated elsewhere though, the reason why you can make profit "you didn't have access to before" is because you take risk that you didn't take before. I don't really understand your last point either but the point is that ROC is unchanged whether you use leverage or not (all it changes the return on equity, profit is determined by the operational side of the business). I am not sure why but you seem to be equating ROE with profit, which doesn't make much sense (i.e. you have a business that makes a certain amount of profit regardless of how much goes to shareholders or creditors).
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    (Original post by webuffett)
    the flaw is that profit hasn't changed...your example doesn't work because the stock that was at $10 is now magically at $20 for the second example. for the mortgage example, i don't get your point. As I think is stated elsewhere though, the reason why you can make profit "you didn't have access to before" is because you take risk that you didn't take before. I don't really understand your last point either but the point is that ROC is unchanged whether you use leverage or not (all it changes the return on equity, profit is determined by the operational side of the business). I am not sure why but you seem to be equating ROE with profit, which doesn't make much sense (i.e. you have a business that makes a certain amount of profit regardless of how much goes to shareholders or creditors).
    Are you serious?

    Look, the value of the stock hasn't changed. You've bought more of it. That's the opportunity you now have with leverage. Previously, you could only buy $10 of stock, making $1 on a 10% appreciation. Now you borrow $10 against your $10 and invest it all in the stock, the stock price is the same [YOU have $20, stock price hasn't changed]. Stock appreciates 10%, you pocket $2, give back the $10 plus interest and hey presto, you've made $2 instead of $1.

    That is tangible gain, nothing to do with equating ROE with profit, I literally have $2 instead of $1 profit. I haven't even calculated ROE here, because there's no need to in order to prove my point.

    If I buy $x worth of anything, and that thing appreciates, I will always make more in absolute terms if I had bought more ex ante. Relatively, I won't make any more, I'll just make the % of appreciation, and that won't change.

    But profit is an absolute measure of performance. ROE is relative, hence why, in trying to show that leverage can increase profit, calculating ROE is irrelevant.

    Yes, you're right that the reason you can make more profit is that you've taken on more risk. ​But this is irrelevant so long as we're talking about accounting profit, not a risk-weighted profit.

    Let's make it clear:

    $10 equity, invest in stock at price $P. Stock appreciates 10%, so net profit = 10P x 1.1 - 10P

    $10 equity and $10 debt (you've leveraged your $10 equity), total investment in stock at price $P is $20. Stock appreciates 10%, so net profit = 20P x 1.1 - 20P - (negligible interest)

    Please tell me you can see that (20P x 1.1) - 20P > (10P x 1.1) - 10P [plug in numbers to your heart's content]

    (obviously you give back the $10 debt, but you don't give back the return on it, the $1 you made on it is yours to keep)

    And what's difficult about the mortgage case? It's a common example of leverage.
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    (Original post by MinorityInterest)
    I didn't say that risk was unchanged at all. I'm merely demonstrating that leverage can increase profits (with the obvious corollary that it can increase losses too), that was all.

    Come on, comprehension 101 here.
    ok but that's not a reason for banks to prefer leverage, modigliani-miller and homespun leverage and all that jazz


    edit: based on your other posts, maybe what you're misunderstanding is that banks can raise either equity or debt? so if they have $10 exposure to an asset and want $20 exposure to the asset, they can either leverage themselves up OR raise new equity. the profit potential will still be there, the riskiness of the firm changes and equity holders will be just as happy in either case (in one case they have a higher ROE but took more risk to take that)
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    I think enforcing drug testing on relevant professionals would be a solid first step. Cocaine is hardly performance-enhancing.

    And before you assume I'm just cashing in on some tired stereotype for even-more-tired laughs:
    http://www.telegraph.co.uk/finance/f...rugs-tsar.html
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    (Original post by Teenage Pirate)
    ok but that's not a reason for banks to prefer leverage, modigliani-miller and homespun leverage and all that jazz


    edit: based on your other posts, maybe what you're misunderstanding is that banks can raise either equity or debt? so if they have $10 exposure to an asset and want $20 exposure to the asset, they can either leverage themselves up OR raise new equity. the profit potential will still be there, the riskiness of the firm changes and equity holders will be just as happy in either case (in one case they have a higher ROE but took more risk to take that)
    Isn't it a reason for firms to prefer leverage? At the firm level perhaps not, but at the level of individual units, there's every incentive to generate more profit if you think you can do so, because that's where your pay check is coming from. Further, even at the firm level, Mod-Miller is about firm value, and has a bunch of assumptions about asymmetric information and various other efficiency conditions; even if we suppose that these hold, is firm value all that matters for the executives? Of course not, they want cash.

    Second, I'm not misunderstanding anything about fundraising. In my example, your choice is between $10 equity you already have, or leveraging it. Think about a hedge fund, or a prop desk, they're given a certain amount of capital and the quickest and cheapest means of expanding that capital is via debt (obviously, the prop desk has access to a lot more capital should the bank decide to pump more into it, but for ROE/compensation reasons it's plausible that the firm wouldn't want to pump more equity in there, and why would they raise any for that purpose either, just diluting shareholders for that?).

    I think you're being too theoretic. This has nothing to do with capital structure theorems or risk-weighting your profits. It's about making tangible profit. When it's 2007 and you think you've got solid bets on various instruments (that will later be worth next to nothing), you leverage yourself up to make an extra buck. Risk isn't your chief concern, the higher-ups don't know any better and you're maxing out your comp.
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    (Original post by MinorityInterest)
    Isn't it a reason for firms to prefer leverage? At the firm level perhaps not, but at the level of individual units, there's every incentive to generate more profit if you think you can do so, because that's where your pay check is coming from. Further, even at the firm level, Mod-Miller is about firm value, and has a bunch of assumptions about asymmetric information and various other efficiency conditions; even if we suppose that these hold, is firm value all that matters for the executives? Of course not, they want cash.

    Second, I'm not misunderstanding anything about fundraising. In my example, your choice is between $10 equity you already have, or leveraging it. Think about a hedge fund, or a prop desk, they're given a certain amount of capital and the quickest and cheapest means of expanding that capital is via debt (obviously, the prop desk has access to a lot more capital should the bank decide to pump more into it, but for ROE/compensation reasons it's plausible that the firm wouldn't want to pump more equity in there, and why would they raise any for that purpose either, just diluting shareholders for that?).

    I think you're being too theoretic. This has nothing to do with capital structure theorems or risk-weighting your profits. It's about making tangible profit. When it's 2007 and you think you've got solid bets on various instruments (that will later be worth next to nothing), you leverage yourself up to make an extra buck. Risk isn't your chief concern, the higher-ups don't know any better and you're maxing out your comp.
    I've not read the book but I've read a paper by Admati and Hellwig (and co-authors) who argue precisely that a more academic approach is needed and I agree with that. For too long people have been treating banks as "special" and just accepting the "bank equity is too expensive" argument without questioning it at all.

    Anyway, the main "violation" of the "normal" world that happens in banking is due to regulation, namely that TBTF/mispriced deposit insurance/???? causes banks to have an implicit guarantee on their debt making it artificially cheap for banks to fund themselves using debt. Forcing banks to raise more equity would make some of their assets likely unprofitable because the subsidy is removed and would reduce bank activity in some sectors. That's pretty much the only drawback I can think of to increasing this.

    As for the "practical" argument, I don't know. I can understand some of the agency issues and issuance cost arguments, but upon some critical examination most of them don't really make that much sense. The thing is, you can't split up "theory" and "practice" like that because theory is all about understanding what happens in practice and even if a lot of academia seems very aloof and distant to you, if you spend some (significant) time thinking about the arguments that are trying to be made a lot of it is actually very sensible. Here's a somewhat related short paper on the topic, the first section is the one worth reading: http://qed.econ.queensu.ca/faculty/m...%20theorem.pdf
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    (Original post by Teenage Pirate)
    I've not read the book but I've read a paper by Admati and Hellwig (and co-authors) who argue precisely that a more academic approach is needed and I agree with that. For too long people have been treating banks as "special" and just accepting the "bank equity is too expensive" argument without questioning it at all.

    Anyway, the main "violation" of the "normal" world that happens in banking is due to regulation, namely that TBTF/mispriced deposit insurance/???? causes banks to have an implicit guarantee on their debt making it artificially cheap for banks to fund themselves using debt. Forcing banks to raise more equity would make some of their assets likely unprofitable because the subsidy is removed and would reduce bank activity in some sectors. That's pretty much the only drawback I can think of to increasing this.

    As for the "practical" argument, I don't know. I can understand some of the agency issues and issuance cost arguments, but upon some critical examination most of them don't really make that much sense. The thing is, you can't split up "theory" and "practice" like that because theory is all about understanding what happens in practice and even if a lot of academia seems very aloof and distant to you, if you spend some (significant) time thinking about the arguments that are trying to be made a lot of it is actually very sensible. Here's a somewhat related short paper on the topic, the first section is the one worth reading: http://qed.econ.queensu.ca/faculty/m...%20theorem.pdf
    I have no problem with academic approaches. But in economics and finance there's a big theory/practice distinction, and whilst it isn't always well defined (or even clear that we could ever find it and define it properly), the distinction can exist in spite of that, and we should be wary of it.

    So in spite of the espistemic problem, I'd argue that theory and practice certainly are distinguishable. Economic and financial models are models; they don't depict the real world, they create a stylised environment in which helps us to understand the real world. They are not reflections.

    I've said before that I don't fully buy the TBTF argument. I don't think it was obvious how regulators would react prior to 2008, I'm not even sure regulators knew how they would react in the crisis, prior to it. It's all very easy in hindsight to say, "Oh well they let Lehman and Bear fail because they were smaller", but I don't think this is necessarily correct. Besides, many people at the time (and probably still now) argued about whether Lehman should have been saved or not; it was not a clear cut decision.

    And I'm not sure it's just that bank equity is expensive, it's the bank equity is expensive relative to debt. I'm all for making banks holding a bit more equity, but I don't think that this should affect the operation side of the business which in many cases works most efficiently with debt funding. Obviously, when the debt is used in risky and illiquid scenarios, you'll want equity behind it, but so many of the transactions that go through banks aren't of this nature and so making generalised claims about the need for equity is crude.

    Thanks for the link, will take a look.
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    (Original post by MinorityInterest)
    Are you serious?

    Look, the value of the stock hasn't changed. You've bought more of it. That's the opportunity you now have with leverage. Previously, you could only buy $10 of stock, making $1 on a 10% appreciation. Now you borrow $10 against your $10 and invest it all in the stock, the stock price is the same [YOU have $20, stock price hasn't changed]. Stock appreciates 10%, you pocket $2, give back the $10 plus interest and hey presto, you've made $2 instead of $1.

    That is tangible gain, nothing to do with equating ROE with profit, I literally have $2 instead of $1 profit. I haven't even calculated ROE here, because there's no need to in order to prove my point.

    If I buy $x worth of anything, and that thing appreciates, I will always make more in absolute terms if I had bought more ex ante. Relatively, I won't make any more, I'll just make the % of appreciation, and that won't change.

    But profit is an absolute measure of performance. ROE is relative, hence why, in trying to show that leverage can increase profit, calculating ROE is irrelevant.

    Yes, you're right that the reason you can make more profit is that you've taken on more risk. ​But this is irrelevant so long as we're talking about accounting profit, not a risk-weighted profit.

    Let's make it clear:

    $10 equity, invest in stock at price $P. Stock appreciates 10%, so net profit = 10P x 1.1 - 10P

    $10 equity and $10 debt (you've leveraged your $10 equity), total investment in stock at price $P is $20. Stock appreciates 10%, so net profit = 20P x 1.1 - 20P - (negligible interest)

    Please tell me you can see that (20P x 1.1) - 20P > (10P x 1.1) - 10P [plug in numbers to your heart's content]

    (obviously you give back the $10 debt, but you don't give back the return on it, the $1 you made on it is yours to keep)

    And what's difficult about the mortgage case? It's a common example of leverage.
    Right, I am really not sure what your point is anymore. Again, your example suggests that what people do if they have $10 is buy a $10 asset at $100 instead of buying it at $10 because leverage equals profit. Instead, there is a $10 asset that someone thinks is cheap and then they buy with $5 equity and $5 debt (or whatever they can get). The difference between the two cases is the asset produces a certain return on capital however you finance it, so you can buy it $100 but you take more risk.

    To make it totally clear, in your first example whilst the return to the investors are different (if you want to make it actually make sense you should say the second guy borrows $5 of a $10 stock), the overall return is the same (10%), no extra profit has been created (this is the difference between ROC and ROE). In this way, no extra profit is created. Your example still makes no sense though...$10 one sec then when you borrow money you can buy another $10, presto! An example that makes sense (that concerns only one investment) would be $10 stock, $10 equity, and $5 equity/$5 debt. With $10 equity it goes up $1 and you make 10%. With $5 in equity, it goes up $1 and you make 20%. Regardless of how it is financed though, the stock only went up $1...yes though, I am aware that a 10% on $20 is greater than a 10% on $10...thanks though.
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    (Original post by webuffett)
    Right, I am really not sure what your point is anymore. Again, your example suggests that what people do if they have $10 is buy a $10 asset at $100 instead of buying it at $10 because leverage equals profit. Instead, there is a $10 asset that someone thinks is cheap and then they buy with $5 equity and $5 debt (or whatever they can get). The difference between the two cases is the asset produces a certain return on capital however you finance it, so you can buy it $100 but you take more risk.
    I have no idea what your second sentence refers to. Where do a mention a $10 asset? I mention $10 worth of an asset.

    (Original post by webuffett)
    To make it totally clear, in your first example whilst the return to the investors are different (if you want to make it actually make sense you should say the second guy borrows $5 of a $10 stock), the overall return is the same (10%), no extra profit has been created (this is the difference between ROC and ROE). In this way, no extra profit is created. Your example still makes no sense though...$10 one sec then when you borrow money you can buy another $10, presto! An example that makes sense (that concerns only one investment) would be $10 stock, $10 equity, and $5 equity/$5 debt. With $10 equity it goes up $1 and you make 10%. With $5 in equity, it goes up $1 and you make 20%. Regardless of how it is financed though, the stock only went up $1...yes though, I am aware that a 10% on $20 is greater than a 10% on $10...thanks though.
    Your analysis is very muddled, and you're making the same mistakes you made before. There is only one investment. The amount you've invested has changed, because you've borrowed to supplement your equity.

    I have given a very specific, simple framework of leverage, and rather than show it's mathematically flawed, you've just garbled stuff about ROC and ROE and how I've magically made money appear. If you think that's the case, please use my model and demonstrate it.

    "Your example still makes no sense though...$10 one sec then when you borrow money you can buy another $10, presto!" YES! Becuase you've borrowed $10 more than you had before. What else do you think you would do with the borrowed money?
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    (Original post by webuffett)
    An example that makes sense (that concerns only one investment) would be $10 stock, $10 equity, and $5 equity/$5 debt. With $10 equity it goes up $1 and you make 10%. With $5 in equity, it goes up $1 and you make 20%.

    Regardless of how it is financed though, the stock only went up $1...yes though, I am aware that a 10% on $20 is greater than a 10% on $10...thanks though.
    The problem is with your example. Why do I have less equity in the second case?

    The whole point of leverage is to increase the amount of money you can invest. It's not a fair comparison to compare one guy with $10 and one guy with $5, you've used leverage to make their profits the same (without leverage, the $5 would only be able to invest $5 and so would only make $0.5).
 
 
 
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