John Cochrane defends equity banking

In part his blog post is a response to my recently published email, but it is also a more general presentation of the equity banking idea.  Here are his closing bits:

The equity of 100% equity financed banks would be incredibly safe. 1/10 the volatility of current banks. It would be an attractive asset. The private sector really does not have to hold any more risk or provide any more money to an equity financed banking system. We just slice the pizza differently. If issuing equity is hard, banks can just retain profits for a decade or so.

Or, better, our regulators could leave the banks alone and allow on on-ramp. Start a new “bank” with 50% or more equity? Sure, you’re exempt from all regulation.

And, in case you forgot, we live in the era of minuscule interest rates — negative in parts of the world; and sky high equity valuations. All the macroeconomic prognosticators are still bemoaning a “savings glut.” A scarcity of investment capital, needing some sort of fine pizza slicing to make sure just the right person gets the mushroom and the right person gets the pepperoni does not seem the key to growth right now.

He chose the excellent title “Tyler: Equity financed banking is possible!”  Do read the whole thing, it is a very good and useful post.

I would add a few points in response.  First, I think equity banking would have to be very tightly regulated to remain as such, more than the status quo.  There always would be incentives to take on more off-balance sheet risk for higher returns.  Second, a much bigger commercial credit sector would have its own maturity mismatch problems.  It might be better than the status quo, but it too likely would end up with a lot of bad regulation, or maybe it would become a no-less-dangerous form of shadow banking.  In general, I don’t think our current form of government can precommit to “no regulation.”  Third, money market funds work pretty hard to maintain fixed nominal value for their depositors.  Admittedly this is a theoretical puzzle, but that we don’t understand the prevalence of debt at various levels (and that prevalence is all the stronger outside the U.S.) does not lead me to think we can alter it as we might wish.  That the theory of capital structure is so weak I do not take to mean that capital structure is so remarkably flexible.  Finally, I don’t think the savings glut is all that relevant for SMEs, and traditional banks still seem to be more efficient at matching borrowing and lending at the local level.  Again, this is a phenomenon we do not understand very well (Fama 1985), but I am not so confident we can undo it.  I also don’t think the savings glut will last much longer, given Asian demographics.

That all said, I would gladly experiment more with equity banking and indeed have written as such in the past.  I am less sure it will do away with our current regulatory dilemmas.  I don’t think it is easy to get around having a part of the economy which is both systemically risky, and also debt-intertangled, as the evolution of shadow banking over the last fifteen years seems to indicate.


The problem with 100% equity banking is that it does not serve the saving purposes of those wanting to participate in the economy but not being able, or willing, to give up their needs for short term access to their savings.

In other words such 100% equity banks would then produce negative interests on all bank accounts. Is that the way to go? Not for me.

'more than the status quo'

Mission accomplished - because the status quo of 1975 would have probably been up to the regulatory task.

" If issuing equity is hard, banks can just retain profits for a decade or so."

What would be the effect on share holder value of this option?

Investors have to fear losing their capital to (1) insiders with asymmetric information/side deals (2) future increases in regulation. These factors are small compared to market risks for a leveraged bank, but significant for an all equity bank.

Banks put a lot of effort into keeping their best traders from making side deals that favor the trader over the bank -- conflict of interest rules; monitoring; giving a %of returns as a contractual bonus; and sometimes letting an employee leave and investing in the ex-employee's new fund.

I think Tyler underestimates how easy it would be to regulate banks in a world without political malfeasance.

Calomoris and Haber explain a political theory of banking highlighting the differences between the US and Canada (Canada has never had a banking crisis) in their book: Fragile by Design.

I think you underestimate how difficult it would be to find a world without political malfeasance in which to do our banking.

I read that Calomiris (sic, a Greek name that phonetically means "Good-Smelling") and Haber book, and one reason Canada banks never failed, as George Selgin can tell you, is that they did not practice "unit banking" as in the USA, meaning every US bank had a local monopoly by law, and could not accept deposits from across state lines, making it paradoxically very profitable but also very brittle (during runs).

As for TC's arguments, he has the better arguments IMO. Grumpy Economist assumes the blockchain is friction free ('instant accounting') which at present in Sci-Fi, and that somehow, unlike debt, equity cannot suffer from irrational runs. As anybody who has studied the stock market in bankrupt stocks knows (i.e. stocks that are literally worthless but trade for a non-zero amount), that assumption is not true. I agree though that equity based banking, akin to what the Islamic banks do, should be more stable that fiat money fractional banking. Just not as stable as people think.

Bonus trivia: a while ago I posted about Roman concrete being made from pozzolan ash alone and that is not true, besides adding burnt lime, you need to compact the Roman concrete in layers with very little water to make it so strong that the Roman Pantheon remains standing today despite internally lacking reinforced metal (amazing fact). I was not aware of this, see here for more information:

I don't think Cochrane argument relies either on the friction level of blockchain or on the inexistence of runs on equity. Cochrane defines a "run" as an event of investors/lenders demanding payment in a way that triggers bankruptcy of the issuer. This cannot happen with equity, so a stock market crash does not qualify as a "crash" in Cochrane terms. Furthermore, it's not really bankruptcy as such that worries Cochrane - it is the bankruptcy of a bank that he's trying to avoid. Notice that Cochrane suggests holding companies that would issue debt and buy bank equity with it. These holding companies can go bankrupt, and they can experience a "run" by any definition of the term. But Cochrane is not concerned about that, because he figures such bankruptcies would be very easy to handle - equity holders of the holding company are wiped out, the debt holders become equity holders, and nothing bad at all happens to the underlying bank or banks. Depositors don't lose their deposits, employees aren't fired in droves, payments don't stop being processed, credit to real businesses is not stopped.

As regards the friction of blockchain - perhaps he's too optimistic about that, I don't know. The argument doesn't depend on the efficiency or even existence of blockchain because ordinary debit card technology can provide the same service - sell an asset, fund a purchase, in seconds. All we need are brokerage-account backed payment cards.

I think you have to consider the impact on local banking. At the national level it doesn't look like a problem. But how is a community bank going to function? Through equity issuance? It seems very likely to me that the relative costs of equity financing versus FDIC-insured deposit financed are much higher for small banks compared to regional/national banks. And how well are they going to serve the needs of small, local business borrowers? It seems to me a near certainty that lending costs for these type of borrowers will rise in an equity-financed big bank only finance world. If your loan type doesn't fit a specific template and cannot be bundled with a bunch of similar loans, it won't be served as well. And maybe that's fine - maybe it's worth the cost of stability in the banking business and allow some cost shifting among different classes of borrowers. Maybe you could move to an equity financed model for banks above a certain size or doing business in multiple states and try to get the best of both worlds.

On a related question, aren't the historically low interest rates a problem for banks and investment in general? My mother has accounts in several banks, all of which can be liquidated immediately. The difference between that and a CD account is so small that it's not worth the lesser liquidity, just in case she should suddenly need the money. Bonds also pay so little it's not worth considering putting any money there. If inflation was higher, interest rates would be higher, and the wasting value of cash would require chasing after investment vehicles that preserve value. But at today's inflation, there's no strong reason not to be in cash.

She also has about an equal amount in her Vanguard accounts, so she has participated in the stock market run up, but at her age (about to turn 90) most people would say she should have her money in low-risk vehicles. Half in cash and half in Vanguard seems about right. But if inflation was high, she'd have to be entirely in bonds, T-bills, or Vanguard just to prevent the money from evaporating. Inflation spurs investment, so aren't today's low inflation and low interest rates a hinderance on the economy?

We already had this. This is what shadow banking was. Didn't work out so well, at least for other than Goldman, though one could say it worked out great for those who cashed out or exited. After all, they would never do something so risky as jeopardize their existence, right?

One motivation for the constitution convention in Philadelphia was that states, those laboratories of democracy, were running amok, printing their own money, adopting debtor protection laws, restricting the remedies of creditors, devaluing debt instruments. The delegates at the convention, often depicted as revolutionaries, were anything but revolutionaries. The were conservatives trying to reign in the anarchists and libertarians. Not much has changed in all these years. Source: The Founders Coup by Michael Klarman.

Banks perform other than lending such as facilitating payments, having business payroll accounts and these need to be fixed income type of debt instruments with all the maturity transformation that takes place. Has Cochrane ever dealt with paying an employee in his life?

A "better" area of study may be separating banks between two functions: deposit banks (for fee payments and safekeeping) and credit (spread lending/investing) banks. Like the 100% equity, I don't see that as viable.

For say eight years, banks have enjoyed static, near-zero interest expenses with concomitant lending at rising rates (prime from 3.25% to 4%) and it hasn't much helped. An outlier is the 30-year fixed-rate mortgage rate which are still below prime at 3.91% last report I saw. No bank should hold a 30-year, fixed-rate asset because the durations of its average retail deposit funding are, say, three years.

Practically speaking, 100% equity banking is impossible.

First, as some above commenters noted, it would make extinct financial intermediation - gathering savers money and lending it to buyers and makers. .

Second, banking is, and has been since the Great Depression, subject to over-competition and regulations which, added to economics (supply and demand), tend to result in low bank margins. Even at zero-cost of funds, loan expenses add up: provisions for loan losses, underwriting, administration, servicing, reporting, etc.

Third, in order to try to earn needed high margins to attract equity investors, significant risks would need to be incurred (high risk, high yield) resulting in even higher loan losses. .

Fourth, the returns on bank equity would be prohibitively low. See one , two, and three.

In conclusion, without financial leverage banks could not somewhat overcome industry low margins and not provide for necessary returns on equity. ergo, the 100% equity structure is not practicable. Financial leverage is covered in Accounting 101 and Finance 101. Please Google "financial leverage."

Now THIS is a good comment. More this please.

Its a non-starter because the interest rates on mortgage lending would be prohibitive.

Hence, fractional reserve banking.

The end.

It's not impossible, but it's not really banking. Rather, it would be pretty similar to a bond mutual fund or a lending club account.

I respond to this debate with John Cochrane here:

Really good, thanks.

Here in Canada, the average bank earns about 3/4 of 1% on its earning assets. It then leverages that at about 20-to-1 to end up with a 15-20% return on equity. Canadian banks can earn these high returns with a net interest margin spread of about 2%. Mortgages are in the range of 3-5%.

John Cochrane correctly argues that in a pure equity, or mostly equity capital structure for the banks, the required return on equity would be lower and attract a different class of investors, i.e., those seeking stability in utility-like investments.

Now in that case, say that bank investors would be willing to settle for an 8% return, similar to what utilities normally pay. That would the cost of your mortgage.

Tell me, how does that benefit society. Going from say 5% on the high side on a mortgage to 8%. Isn't it cheaper for society to have a lower cost of loans including the cost of bailing out the occasional bank than to have everyone paying a higher cost of loans?

Either way, society pays for the inherent risk in banking. The current system is more efficient.

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