Celso Toledo wrote me from the Virgin Islands, where he is vacationing. He is enthralled with the BNC book that CESG urged us all to read a year ago.
It is indeed a Must Read and the clarity and persuasiveness of the authors are stunning.
The punchline is this: banks issued (and still issue) too few equity and too much debt before the crisis because debt had both implicit guarantees (moral hazard) and preferred tax treatment. This in turn made them more vulnerable to adverse shocks. A fall in the value of their assets then quickly depleted the little equity they had and as consequence debt default followed and hell was set loose.
Policy advice: banks have to hold more equity! Besides, if everyone is forced to finance its operations this way, there is no stigma effect and hence, in equilibrium, it may not be that much more costly to reestructure the liability side of banks´ accounts. More equity has a positive effect on the price of debt too, since it renders debt default less likely. As Ken Rogoff once said: "we need more equity to absorb shocks hitting the world´s financial system".
So far, so good.
However, the authors insist vehemently on an undue comparison throughout the book. Every other page they say "why a real sector company finances most of its investments via equity whereas banks do it thr debt?" And then they repeat the moral hazard argument and bla bla bla...
BUT THIS IS A WRONG COMPARISON TO MAKE.
As other economists before me pointed out, banks are not so akin to real sector companies as the authors implicitly claim. Here is why:
Society values liquid assets. You and me and Toledo and Toledo´s firm benefit from being able to purchase liquid short-term assets with non-variable payment schedules. In other words: debt has a social value (if u disagree think for a second if u would like to see your bank stop issuing bonds to you, offering instead only variable income assets). Now, who do you think is best positioned to provide this service for us? THE BANKS. Firms in the real sector have to focus on their products, shouldnt be on the business selling short-term securities around. Banks have a comparative advantage on that because they can put the law of large numbers to work, and thus at the same time they finance people and firms they also provide others with valuable short-term assets which are theirs short-term liabilities.
I got to fly now, back to Canada at last! Read the book, it is worth your while.