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FRBSF WEEKLY LETTER June 20, 1986 Leverage And Double Leverage In Banking Banking firms, like other corporate entities, finance their activities by issuing debt and equity securities. The greater the ratio of debt-to-equity used in fina.nCingthe firm, the more the firm is said to be "leveraged." should not vary with the degree of leverage employed. Thus, a firm with a given portfolio of assets should theoretically be unable to make its shareholders better off simply by manipulating the degree of leverage. In most industries, firms are free to determine their own degree of leverage, disciplined only by market forces. This is not true in the banking industry where the financial structure of a banking firm is seen to have important public policy implications. In particular, because a large proportion of a bank's debt consists of deposits, regulators wish to ensure that banks maintain adequate equity or "capital" to protect depositors against a decline in the value of the bank's assets. Regulators have a special interest in maintaining public confidence in deposits because deposits make up the bulk of the nation's money supply. Leverage and taxes There is some debate over whether this so-called "invariance proposition" still holds when a major distorting factor such as tax policy intrudes. In particular, interest payments on debt are deductible against corporate income whereas dividend distributions and retained earnings are not. Some analysts argue, therefore, that shareholders would prefer a high leverage strategy because such a strategy would "shield" more of the firm's income from taxation and thereby increase shareholders' after-tax earnings prospects and hence, their wealth. Regulators have been concerned in recent years about the adequacy of bank capital and most recently have revised bank capital standards. The purpose 'of this Letter is to review the nature of bank leverage in light of the broader theory of the optimal financial structure of the firm. As we shall see, this helps in understanding problems encountered in imposing minimum capital standards on financial institutions. Theory of leverage The effect of increased reliance on debt in a corporation has two components. First, increased leverage raises the expected return (earnings per share) to shareholders, tending to make those shares more valuable. Second, increased reliance on debt weakens the firm's ability to survive fluctuations in the value of its assets without default and subsequent bankruptcy. These two components of the effect of increased leverage have offsetting effects on the price per share of the firm's equity. Indeed, economists Franco Modigliani and Martin Miller demonstrated that, in a simplified theoretical framework, the effects would be exactly offsetting. The value of shares and, hence, the value of the firm, It can be argued, however, that these advantages of debt at the corporate level are offset by disadvantages at the level of personal taxation, where the proceeds from equity ownership receive preferential treatment compared to interest income. (That is, capital gains are taxed at a rate lower than interest income.) The result is that debt and equity may well have different "clienteles." For individuals facing high personal tax rates, the after-tax cost disadvantages of equity at the corporate level are more than offset by its advantages at the personal level. The opposite is true for individuals facing low tax rates. The quantity of debt and equity willingly held by the marketplace and the equilibrium yield will be determined by the relative strength of the demand by the two clienteles. As Merton Miller has pointed out, this "clientele effect" will determine the relative shares of debt and equity for the economy as a whole, but not the optimal leverage for the individual firm. Managers therefore can make different decisions about leverage without adversely affecting shareholder wealth. This may explain why, at least among nonfinancial corporations, we observe the successful co-existence of both highly leveraged and all-equity firms. FRBSF Leverage in banking Such clearly is not the case among financial intermediaries____._ allof which are highly leveraged. This observation is, at least partly, definitional. Financial intermediaries are firms that have specialized in converting one form of financialliabilityto another.They thus issue significant quantities of debt. It follows, therefore, thaHrue financial intermediaries~.banks, savings and loan associations, consumer finance companies, and so on - will tend to be more highly leveraged than nonfinancial corporations. Indeed, equity representsonlyabout5 percent of the total sources of funds for banks and thrifts and 15 percent for consumer finance companies, against over 70 percent for nonfinancial corporations. Simply distinguishing this set of institutions as highly leveraged does not mean that the invariance proposition no longer holds. Firms in the business of making loans could be unleveraged and still competewithfinancial intermediaries. Indeed, all-equity enterprises such.<ls mutual funds coexist with financia.l intermediaries in loan markets. Why then do bank regulators today continually struggle to keep le\ferage from increasing still further? .If the invariance proposition truly held in the case ofbanking, the cost (in terms of shareholder wealth) of complying with regulatory capital. standards would be zero and such a struggle would not persist. Deposit protection and leverilge One possible explanation for .the apparent violation ofthe invariance proposition .is depositor protection policy, wherebyholders of deposit debt are protected from risk either explicitlythrough deposit insurance schemes - or implicitly through the actions orbanking agenciesthat have the effector protectingdebt~ holders, insured or not. To the extent that such protection is available to banks at <lcost lower than its expected insurance value, banks can increase their expected earnings (and shareholder wealth) by increasing their use of such debt. This hypothesized relationship between deposit protection and leverage is supported by the data (see Chart). Bank debt-to-equityratios climbed sharply immediately after the introduction of deposit insurance in 1933 and· fell backonly when capital regulation was pursued inearnest in the early 1950s. Since then, debt-to-equity ratios have risen steadily asthe degree of deposit protection has grown. The notion that deposit protection induces increased leverage also finds support in the fact that leverage is typically greater in depository intermediaries than in nondepository intermediaries such as consumer finance companies and insurance companies. These other financial corporations typically rely three to five times more on equity than depository intermediaries such as banks and thrifts. Data on the market value of the shares in financial corporations provide additional support. Despite the fact that some banking and thrift institutions have portfolios that are "under water" in terms of market value (that is, their liabilities exceed the market value of their assets), their shares continue to have positive market value. An unreported asset - deposit protection - could account for this phenomenon. Regulation of bank capital The strength of existing incentives to increase leverage is evidenced by the difficulties regulators encounter in regulating capital. Numerous factors have made capital standards less binding in practice than in theory. One factor is the mechanism employed by regulators to determine capital standards. Without any hard theory to guide them, regulators have employed peer group analysis to devise capital standards. While such a mechanism permits identification of banks whose leverage is much greater than the norm for comparable institutions, it does not protect against gradual increases in leverage for the peer group as a whole. There also has been a legitimate debate as to precisely what constitutes "capital" for the purposes sought by regulators, namely, to protect depositors from the loss of their funds and thereby protect the banking system from the consequences of runs and failures. For example, because subordinated debt (that is, debt obligations that are subordinate to a bank's obligations to its depositors) in theory protects deposit debt in the event that the value of a bank's assets deteriorates, banks have argued (sometimes successfully) that the regulatory definition of "capital" could include subordinated debt in addition to true equity. This expanded definition raises an important question, however. Why would banks wish to Deposit Insurance And Trends In Leverage Percent Percent 100 90 80 70 1600 I Start of Federal Deposit Insurance (1933) 1200 60 ,,-_....... 50 40 30 -'''"'\ ,r·" J'.' % Deposits Insured -e (Double leverage can be detected by examining the balance sheets of the bank and its parent holding company. Specifically, if the parent BHC has less equity capital than the bank it owns, some of the BHC debt must have been downstreamed to the bank as equity.) The rationale of double leverage 800 20 10 a is the same whether simple or double leverage internal financing techniques are employed. 400 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1984 issue subordinated debt rather than equity since - according to the invariance proposition at least - equity and (unprotected) debt would be equally costly? One possible answer is that the protection afforded deposits "spills over" onto other forms of bank debt as well. That is, the marketplace perceives subordinated bank debt as enjoying some default protection as well, since regulators typically close banks before such debt is jeopardized. The effects of this protection argue that regulators should not include subordinated debt in capital adequacy standards. Bank holding companies and leverage The bank holding company (BHC) form of banking organization also can make it difficult for regulators to maintain desired leverage standards in banking. A bank holding company is a corporation that issues its own debt and equity securities and that invests the proceeds in the debt or equity of a subsidiary bank. This process of using funds is referred to as "downstreaming." When the parent BHC issues debt to acquire the debt of the subsidiary bank, the phenomenon is referred to as "simple leverage." When the proceeds of the parent debt issue are downstreamed as equity, the practice is referred to as "double leverage." To an outside investor, leverage of the consolidated enterprise Although BHC shareholders should be indifferent bet~een single and double leverage techniques on the basis of wealth considerations, they appear to prefer the double leverage technique. By employing double leverage, BHC management can use debt to satisfy capital adequacy standards that are more stringent for banks than BHCs. Double leverage financing is particularly interesting because it takes place despite other supervisory policies that would be expected to favor simple leverage. In particular, bank supervisors limit the payout of dividends by banks. In the case of double leverage finance, it is precisely these dividend flows that must be "upstreamed" to service the BHC debt. In contrast, if simple leverage were used, the revenues of the bank would have flowed out as interest payments to the BHe. Bank supervisors consider interest payments an expense and do not impede their flow. Since simple leverage gives the BHC freer access to the revenues of the subsidiary bank, there is less risk of debt-servicing or default problems. The fact that BHC shareholders are willing to expose themselves to greater risk in exchange for avoiding capital standards supports the notion that capital standards are costly to banking organizations. In conclusion, it appears that deposit protection causes the invariance proposition to be violated in the banking industry. It induces managers of banking firms to resist capital regulation and sets the stage for what is likely to be a long-lived struggle between banks and regulators of bank capital. RandallJ.Pozdena Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco, or of the Board of Governors of the Federal Reserve System. Editorial comments may be addressed to the editor (Gregory Tong) or to the author .... Free copies of Federal Reserve publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 974-2246. uo~6U!450m 040PI !!omoH 40~n O!UJOj!l0) U060JO 0pOA0U OUOZPI:) O)SI)UOJ~ 0115011:) UOS JO ~U08 aAJasa\:J IOJapa~ ~uaw~Jodaa 4)Joasa~ BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) Selected Assets and Liabilities Large Commercial Banks Loans, Leases and Investments 1 2 Loans and Leases 1 6 Commercial and Industrial Real estate Loans to Individuals Leases U.S. Treasury and Agency Securities 2 Other Secu rities 2 Total Deposits Demand Deposits Demand Deposits Adjusted 3 Other Transaction Balances4 Total Non-Transaction Balances 6 Money Market Deposit Accounts-Total Time Deposits in Amounts of $100,000 or more Other Liabilities for Borrowed MoneyS Two Week Averages of Daily Figures Change from 5/22/85 Dollar Percent! Amount Outstanding Change from 5/21/86 202,276 183,412 52,386 66,968 38,922 5,627 11,028 7,836 200,491 48,297 33,792 15,737 136,457 5/14/86 190 185 489 244 48 8 12 7 -1,318 -1,646 - 650 20 347 10,197 9,943 149 3,881 4,843 266 564 817 7,644 4,464 - 6,269 2,621 560 5.3 5.7 0.2 6.1 14.2 4.9 4.8 11.6 3.9 10.1 -15.6 19.9 0.4 46,440 440 3,063 7.0 2,162 552 - 5.6 36,234 23,854 - - 135 405 Period ended Period ended 5/19/86 5/5/86 Reserve Position, All Reporting Banks Excess Reserves (+ )/Deficiency (-) Borrowings Net free reserves (+ )/Net borrowed( -) 28 41 13 15 39 55 Includes loss reserves, unearned income, excludes interbank loans Excludes trading account securities Excludes U.S. government and depository institution deposits and cash items ATS, NOW, Super NOW and savings accounts with telephone transfers S Includes borrowing via FRB, TT&L notes, Fed Funds, RPs and other sources 6 Includes items not shown separately 7 Annualized percent change 1 2 3 4 2.3
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