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Admati and Hellwig

Admati and Hellwig

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07/10/2013

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129NINE
Sweet Subsidies
I don’t know how you measure that subsidy. . . .
at’s why they say it’sinvaluable.
 Mark Zandi, chief economist of Moody’s Analytics, part of the credit rating agency Moody’s, April 

Y

B

 

that the content of a pizza might depend onhow it is cut is absurd.
 
Yet when banks borrow excessively and econo-mize on equity, the total “pie” available to their investors grows.
Whenbanks borrow, they bene
t from subsidies that they would not enjoy if they relied more on equity.
 
e more banks borrow, the larger are the subsi-dies, as if the pizza chef added more cheese when the pizza was cut intomore slices.
e main source of subsidies for banks is the support the government pro- vides to protect banks, their depositors, and sometimes their other creditorsand their shareholders. Banks and their creditors bene
t from explicit andimplicit government guarantees. Depositors are protected by deposit insur-ance, which is guaranteed by the taxpayers. Other creditors, and even thebank’s shareholders, bene
t if the government provides additional equity toprevent the bank from going bankrupt—for example, in a crisis.Because depositors and other creditors count on this support, they arewilling to lend to banks on more favorable terms than the terms they wouldrequire otherwise. In particular, the interest rates banks must pay on theirdebt are lower than they would have been without government support.
isgives banks strong incentives to prefer borrowing over other types of fundingthey might obtain for their investments. In e
 
ect, taxpayers subsidize the useof borrowing by banks. Paradoxically, these subsidies encourage banks to bemore fragile.
ey reinforce the distortions from the bias that heavy borrowers
 ([FHUSWHGIURP7+(%$1.(561(:&/27+(6E\$QDW$GPDWLDQG0DUWLQ+HOOZLJ&RS\ULJKWE\3ULQFHWRQ8QLYHUVLW\3UHVV7ROHDUQPRUHDERXWWKLVERRNSOHDVHYLVLWKWWSSUHVVSULQFHWRQHGX1RSDUWRIWKLVWH[WPD\EHGLVWULEXWHGSRVWHGRUUHSURGXFHGLQDQ\IRUPE\GLJLWDORUPHFKDQLFDOPHDQVZLWKRXWSULRUZULWWHQSHUPLVVLRQRIWKHSXEOLVKHU
 
130
CHAPTER NINE
have toward even more borrowing, the e
 
ect of debt overhang discussed inChapter
.Excessive borrowing by banks can expose the public to great risks. A bank exposing the public to risks is similar to an oil tanker going close to the coastor a chemical company exposing the environment to the risk that toxic
uidsmight contaminate the soil and groundwater or an adjacent river.
Like oiltankers or chemical companies that take too much risk, banks that are toofragile endanger and potentially harm the public. Cleaning up coastlines andrivers and bailing out banks are all costly to taxpayers.
e risks and costs tothe public in all these cases are very real. For society, containing the risks of oil tankers, chemical factories, and banks is therefore important, even if thereis a cost involved. In the case of banks, in fact, requiring more equity pro-duces large bene
ts at virtually no cost to society.Explicit and implicit government guarantees have perverse e
 
ects on theextent of borrowing and risk taking of banks.
e preferential tax treatmentof debt also encourages borrowing. With the additional borrowing, the in-centive to take excessive risks, discussed in Chapter
, becomes stronger.Government guarantees and subsidies thus reinforce the e
 
ects of bank-ers’ compensation and the focus on ROE, as well as the e
 
ects of debt over-hang, all of which encourage borrowing and risk.
e prospect of becomingsystemically important or too big to fail provides banks with incentives togrow and become more complex.
e implicit guarantees reduce the fundingcosts of the too-big-to-fail institutions and give these banks an advantageover other banks and over other companies in the economy. If banks respondto these incentives by growing and becoming more complex, this in turnincreases the damage to society should these institutions become distressedor insolvent. It is as if the government subsidized ever larger tankers goingever closer to the coast.
Isn’t It Wonderful to Have Such an Aunt? 
To see how guarantees work, let us again consider the example of Kate whotakes out a mortgage to buy a

,

house that she sells a year later.
Inthe case discussed in Chapter
, we assumed that Kate borrows

,

at
percent interest and puts down

,

in down payment or initial equity.
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SWEET SUBSIDIES
131
If Kate settles her mortgage and pays all the interest a
er a year, she owes

,

, including

,

in interest, to settle the mortgage a year later. If Kate has a nonrecourse mortgage, as we have been assuming, she does notpay her debt in full when the house subsequently declines in value to below the amount of the mortgage debt,

,

.
We can assume that the
per-cent interest rate that Kate is charged includes some compensation for therisk to the bank of not being paid in full.Now let us change the example slightly by assuming that Kate’s Aunt Claireo
 
ers to guarantee Kate’s mortgage. If the house subsequently sells for lessthan Kate owes on her mortgage, Aunt Claire will make up the di
 
erence.
e local banker knows that Aunt Claire is wealthy. With the mortgage guar-anteed by Aunt Claire, the bank faces virtually no risk and therefore allowsKate to borrow at the riskless interest rate of 
percent.In borrowing

,

at
percent instead of at
percent, Kate pays only 

,

in interest instead of the

,

she must pay without the guarantee.She saves
percent in interest on the loan of 

,

, which amounts to

,

for the year.
is leaves Kate with more money a
er paying the mort-gage debt. For example, if the house subsequently increases in value by 
per-cent to

,

, we saw in Chapter
that Kate will be le
with

,

, a

percent return on her equity investment, if she borrows at
percent. If sheborrows at
percent and owes only 

,

, she will instead have

,

 le
, a

percent return on her equity investment, a
er selling the house for

,

and paying her mortgage debt.
e saving of 

,

in interest will also so
en the blow should Kate losesome of her investment, assuming that she is still “above water” and able to pay her mortgage. For example, if the house sells for

,

, Kate will be le
 with

,

if she borrows at
percent, a loss of 

percent of her investment,but she will have

,

if she borrows at
percent, losing only 

percentof her investment. Similarly, she will lose less if the house declines in value by 
percent to

,

. In the worst-case scenario, if the house ends up below 

,

in value, Kate will lose everything whether she borrows at
percent or
percent; Aunt Claire’s guarantee does not bene
t Kate in this case.
e situation is summarized in Table
.
.
e top panel reviews the casediscussed in Chapter
, in which Kate pays
percent interest, while the bot-
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