Customers judge their banks by the quality and variety of services they provide — not by size. Legislators, on the other hand, frequently mistake banks' size as the most important indicator of their stability. In fact, bank stability depends not on size but on the riskiness of a bank's assets, as well as which of the bank's sources of funding bear that risk. Market discipline provides one way to control these risks.
Asset risks and funding risks are inherently bound up with one another. Yale University professor Gary Gorton discusses how risky secrets lurking on the asset side of banks historically triggered bank runs once they became public knowledge in his book Misunderstanding Financial Crises. In the U.S., deposit insurance became the solution to that problem.
But bank stability can also be maintained if banks fund a significant amount of their investments with long-term bonds and equity such as common stock. Since long-term bonds are liabilities, while equity measures the bank's net worth of total assets minus total liabilities, long-term bonds and equity would serve as the bank's capital, as Professors Anat Admati and Martin Hellwig made clear in their book The Bankers' New Clothes. Unlike depositors, bond and equity investors are primed to take on the downside risk of a bank's assets.
Former finance professor and Goldman Sachs partner Fischer Black suggested 40 years ago that banks should fund at least half of their investments with long-term bonds and/or equity, with the remaining funding coming from deposits. Such a rule would mean that for every dollar a bank raises from depositors, it must find bond and equity investors willing to fund at least another dollar. This puts bank risks back into investors' hands.
The market discipline in Black's proposal arises from his recommendation that we measure a bank's equity at market value, rather than book value computed by the bank's accountants. Using market value of equity instills market discipline because it can fluctuate quite a bit, in accordance with equity investors' perceptions of the risk lurking on bank balance sheets. Unpleasant surprises mean the stock price and market value of the bank's equity fall as investors sell. This market discipline puts the corporate finance side of the bank in conflict with the bank's asset managers and loan officers, who now have to check their own risk-taking so the bank does not have to find new investors.
Finally, since a firm's risk of default rises with its debt-equity ratio, banks that rely more on equity would be safer — especially since the slightest hint of those secrets will cause equity investors to sell their assets. In Black's world, size depends on the collective decisions of the bond and equity investors, as well as depositors. If anything, a bigger bank means a better bank, just as a rise in Apple's market share for phones and computers indicates that customers think Apple sells a superior product.
But that's not the world we live in today. In this world, our tax laws favor debt over equity. Banks are backed by mispriced and even under-funded deposit insurance. U.S. banks measure capital at book value rather than market value. While bank capital requirements increased in the post-Basel Accord era, the guidelines specify so-called risk buckets, which assign different capital charges by asset type in an ad hoc manner, effectively lowering capital requirements.
For example, the Recourse Rule, finalized on Nov. 29, 2001, lowered commercial bank capital charges from the standard 8% to 1.6% for holdings of highly-rated structured product tranches originated by investment banks. That rule change helps us to understand why some larger banks increased their holdings of the very products that went bust in 2007-09. While Basel III calls for increasing capital requirements, risk buckets still exist today and work against market discipline.
All told, our current legal and regulatory framework invites bank failure even five years after the passage of Dodd-Frank. Legislation focused on size does not address the problem, since it does nothing to reestablish the market discipline missing in the United States since before the Great Depression. Measuring equity at market value would restore that much-needed discipline.