The upside of more equity for big financial institutions

This week marks the fifth anniversary of the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the financial reform law that overhauled the U.S. financial system in the wake of the 2008-2009 housing and financial crises. Although key parts of the law have not yet been implemented, the Federal Reserve finalized one key regulation  this past week. The new rule requires large financial institutions deemed “systemically important” to have a higher share of their funding in the form of equity, including shares in the financial institutions, cash on hand, and savings.

Why do regulators want these big financial institutions to be more equity funded? And does this mean that big firms will have less money to lend to businesses and individuals?

First, a point of clarification. When regulations require financial institutions to increase equity funding, this is often described as requiring them to “hold more capital.” That phrasing invokes an image of banks sitting on their reserves instead of lending out that money to the broader economy. But that’s not what’s going on. This new regulation and others like it are concerned with how banks fund themselves, which has ramifications for their stability and the stability of the entire economic system.

Financial institutions, like other businesses, have a choice when they want to fund an investment or asset purchase. They can fund it via equity (selling more stocks, using their own revenue or savings) or via debt (borrowing). The relative mix of equity and debt financing happening across the economy can have significant effects on how economic swings affect economic stability. Basically, more equity financing dampens economic volatility, and more debt amps it up. The same is especially true for financial institutions, as the recent financial crisis demonstrated.

A simple example can help make this point. Say you purchase an asset, such a house or a bunch of shares in a company, and it costs $100,000. You fund that purchase with $20,000 of your own savings (equity) and an $80,000 loan (debt). If the price of the asset goes up by 20 percent to $120,000, then the extra $20,000 goes to the equity. That’s a 100-percent return on your equity investment. But if the price of the asset goes down by 20 percent to $80,000, then your equity is entirely wiped out—a negative 100-percent return.

But what if equity were a higher percentage of your funding, say doubled to $40,000? In this case, only $60,000 in borrowing is required. Then a 20 percent increase in the asset price would still give a return of $20,000 but that’s only a 50 percent return. But a 20 percent decline would still leave $20,000 left in equity. The return would still be negative, but the equity wouldn’t get entirely wiped out.

This example should make clear why individual financial institutions want to finance themselves via debt and why the overall system might be better served by more equity. The positive returns are amplified with debt, but so are the negative ones. It make sense that we’d want big financial institutions whose collapse would imperil the entire system to be more resilient by funding themselves with more equity.

But what would more equity funding for these big financial firms mean for the broader economy? Some research shows that increased equity funding wouldn’t be a drag on bank lending or economic growth. Economists Anat Admati of Stanford University and Martin Hellwig of the Max Planck Institute have done quite a bit of this research and lay out their arguments in their book “The Bankers’ New Clothes”

Yet, as the Roosevelt Institute’s Mike Konczal points out on Vox, not all equity is the same. The financial system is complex and so capital comes in a variety of flavors depending upon their level of risk and other factors and can be measured in a myriad of ways. Regulators not just in the United States, but across the globe will have to figure out the right mix of different kinds of equity.

Then there’s the matter of from where these big financial institutions will raise the equity and what the opportunity cost of using equity to “backstop” banks is. But the existing research is persuasive that getting banks to use more equity to fund themselves would lead to a more stable economy benefitting the vast majority of the population.