Monday, September 26, 2011

Blame the investors

Martin Wolf has a great post about how high target returns on equity are creating financial instability:

Banks love using the line "without high returns (and consequently leverage) we won't be able to attract equity investors." Bullshit. What will happen is their stock price will go down until its attractive to investors again. Every equity investor wants the bank to take as much risk as possible. They have unlimited upside and limited liability so they can't lose more than their original investment amount. What typically keeps the banks in line are creditors, they receive a fixed return on their investment but can still lose everything if the bank really screws up. Unfortunately in our Too Big To Fail world the creditors can't lose money either. If we bail out bank creditors (who are often other banks) there is no market check on the risky investments of banks. Without this system of checks banks will take as much risk as they possibly can, staying one step ahead of regulations. Banks are supposed to be prudent stewards of capital and risk management is supposed to be their primary business. But now our banking system is less stable than before, perhaps banks have better capital positions but these won't last long as equity investors demand higher returns (more risk).

I have this comic on my wall at work:

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