Beware of Banks with Too Much Debt

The ratio of debt to assets for U.S. banks has ranged from 87 percent to 95 percent over the past 80 years.
David KatzFebruary 18, 2014

“History does not repeat itself, but it does rhyme,” says Ilya Strebulaev, quoting a line attributed to Mark Twain as a way of answering the question of whether the next financial crisis would look like the one that began in the fall of 2008.

Strebulaev, an associate finance professor at the Stanford Graduate School of Business, was making the point in a recent interview that although the next inevitable collapse of the financial system would be different from the events following the collapse of Lehman Brothers, it would have some similarities.

Inevitable? Yes. To be sure, the exact time and cause of the debacle can’t be predicted. But a big shock to the global financial system – like the collapse of a nation like Cyprus, say, or the bursting of a real-estate bubble – is sure to trigger devastating reverberations because “the banking system has not been really made stable,” says the professor, who directs the school’s executive education program on “The Emerging CFO.”

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Because the system hasn’t been strengthened enough by rule-makers in the wake of the Great Recession, it won’t be able to withstand a cataclysm, he reasons, noting three basic sources of weakness: capital requirements under Basel III that aren’t “as stringent as we believe they should be”; increasing correlations among the various assets that banks hold, making them especially vulnerable to volatility in the values of those assets; and misguided bank corporate governance that has aligned the incentives of managers “such that they prefer to risk or to gamble.”

Strebulaev, co-author of a recent working paper that sees the current distribution of debt from bank depositors to banks to corporate borrowers as a “supply chain,” thinks CFOs need to become particularly alert to exactly how fragile their lenders are.

The long-term indebtedness of U.S. banks puts them into a precarious position, he thinks. Their average leverage, gauged as the ratio of debt to assets, has ranged from 87 percent to 95 percent over the past eighty years, according to estimates based on historical Federal Deposit Insurance Corporation data.

Until now, however, corporate finance executives in the process of trying to raise money from banks haven’t cared much about knowing about how or where banks got their funds. What was essential to know about were the interest rates and the conditions attached to a specific loan.

For a small company negotiating a single loan, that still might be enough knowledge, according to Strebulaev. But for larger companies, especially ones seeking to cultivate a relationship with a bank, “you need to know the source of financing,” he says.

That’s because banks, in their roles as intermediaries in the debt supply chain, are increasingly sensitive to “frictions” in their financial relationships with their creditors (bank depositors and other lenders) and commercial borrowers. The main reason for their sensitivity is that banks’ excessive debt loads give them less flexibility to deal with the increased volatility in the rest of the supply chain, according to Strebulaev.

One such friction is the variability of default costs in the bankruptcies of borrowers – a particularly worrisome factor in times of economic crisis. Another risk resides in what, viewed in the near term, is a benefit to both lenders and borrowers: banks’ ability to deduct debt from the interest income they get from borrowers.

Virtue Versus Viciousness
The way Strebulaev describes it, a virtuous cycle looked at in terms of individual companies has grown vicious in terms of systemic risk. To show how the system rewards overleveraging, he compares two hypothetical banks, one with relatively small amounts of debt and the other leveraged to the hilt.

 The bank with the heavier debt load will be able to get a bigger tax deduction. If it so desires, it can use that extra cash to charge lower interest rates to customers – and win a bigger market share from the more prudent bank.

Thus, the system packs a strong incentive for banks to borrow. While that provides a big advantage to companies in terms of the cost of capital, it spawns a huge economic risk for banks, particularly in an economic crisis. “Even if a small number of firms default, it can tip the bank into distress because they’re over-levered,” says Strebulaev. “The solution is for firms to borrow less from the bank, because it will take a much larger shock for the bank to get into stress. That is what I mean by supply chain.”

Yet CFOs earn their keep by improving the lot of the companies they work for, not by saving the system as a whole. What can individual finance chiefs do to keep funds flowing to their firms?

By choosing banks that will be in a position to re-up their revolvers in the face of a recession or provide relatively cheap lending when times are good, according to Strebulaev.

First, they should gauge the relative long-term stability of a bank by checking out two kinds of publicly available data: the banks’ mean Tier 1 core capital and its Tier 1 leverage ratios. “If the bank is at the minimum Tier 1 capital, that means that if there is going to be a recession, that bank is going to be the first to go under,” he warns.

Even though it may cost a lot in extra fees and take time, finance chiefs should also establish relationships with a number of banks, rather than rely on just one.  That’s especially true for companies with volatile cash flows and ones with fortunes that generally track those of the broad economy, according to Strebulaev. (Anti-cyclical companies, like firms that sell gold, would have less need for such diversification in a crisis.)

Such companies would do well to look deeply into the health of their banks to prevent a loss of access to funds when they most need it, Strebulaev advises. Referring to a well-known bank failure, he said, “let’s say you had a credit line revolver with IndyMac back in the crisis. What would have happened to your commitment? Most likely it would have gone away.”