08/01/2011 09:31 pm ET Updated Oct 01, 2011

Reset Equity-Risk Formula for Banks

Originally published in The Atlanta Journal-Constitution on July 29, 2011.

By Robert Dell

What the AJC's recent investigation into the failure of 65 Georgia banks showed is that both bank executives and their regulators lacked incentives for maintaining equity capital commensurate with the risk of making aggressive bets on real estate in the latter stages of the real estate boom. Instead, regulated banks accentuated both the boom and the bust.

For banks with assets under $1 billion, which comprise 90 percent of U.S. banks, 74 percent of their loans and securities are real estate risk-related, according to banking scholar Alex Pollock. On the surface, the banking business looks much like the real estate investment trust ("REIT") business these days. REITs derive revenue from the leasing and sale of properties they own. Banks get revenue from interest on loans, interest which is paid from the leasing and sale of properties securing those loans.

Whereas banks are more exposed to risk in residential for-sale properties versus REITs, which are more affected by risk in rental properties, these two major real estate categories experienced a comparable boom and bust in recent years.

So why weren't REITs hit with large waves of failures the way banks were?

REITs are lightly regulated and compete for credit partially by offering creditors more safety. As a result, REITs are typically capitalized with tangible equity exceeding 30 percent of assets. There is evidence to suggest REITs were a moderating influence on the real estate boom and bust.

Banks are heavily regulated and bank creditors are, to a great extent, insured by government deposit insurance and other safety net policies. Consequently, bank depositors don't discipline bank risk-taking and banks typically hold tangible equity of less than 6 percent of assets.

This was not always the case. A century or more ago, banks were capitalized more like REITs are today, holding equity of at least 30 percent of assets. University of Georgia banking economist George Selgin, an advocate of free banking, explains:

In a world without insurance ... [a bank can] only attract deposits by putting its owners' capital at stake. Other things equal, the more capital a bank has, the more likely it will succeed in attracting risk-averse depositors ... [B]anks can also attract such depositors by holding low-risk assets ... In the past, banks used both sorts of strategies to gain market share, often taking out advertisements in newspapers in which they supplied pertinent balance-sheet details.

Historical perspective is warranted. If we define "banking crisis" to mean bank failures and system losses exceeding 1 percent of a country's GDP, we find that in the period 1875-1913, the "golden era" of laissez-faire, there were only four banking crises worldwide. By contrast, in the period 1978-2009, about 140 banking crises occurred worldwide.

The major difference between the two periods has been the expansion of taxpayer-backed deposit insurance. Federal deposit insurance began in 1933, but it was initially opposed by Franklin Roosevelt, his treasury secretary, the Federal Reserve, major bank executives, virtually all economists and Sen. Carter Glass (of Glass-Steagall). The reason was that in the two prior decades experimentation with state deposit insurance resulted in banking collapses in all eight states that had tried it. It was widely acknowledged to have been a failure. At his first presidential press conference, Roosevelt offered his own assessment:

I can tell you as to guaranteeing bank deposits my own views ... The general underlying thought behind the use of the word 'guarantee' with respect to bank deposits is that you guarantee bad banks as well as good banks. The minute the government starts to do that the government runs into a probable loss.

Deposit insurance was widely recognized as special interest legislation. Sen. Henry Steagall of Alabama, the primary sponsor, represented a state where single-location unit banks were politically influential. Deposit insurance helped protect these banks from competition from larger, more-diversified multi-branch banks, since depositor risk was reduced in the competition for their deposits.

Financial economist Charles Calomiris finds that empirical studies of banking in the modern era -- an era of unprecedented frequency and severity of bank losses -- have "concluded uniformly that deposit insurance and other policies that protect banks from market discipline, intended as a cure for instability, have instead become the single greatest source of banking instability."

The cure for banks is more equity and less government entanglement. Then banks would perform more like REITs -- with a healthy focus on the long-term.