A world without depbt

EDWARD HADAS

I have a dream: a world without debt, and with much more equity. The fifth anniversary of Lehman Brothers’ bankruptcy is a month away, and regulators have recently forced both Deutsche Bank and Barclays to issue more shares.

Some regulators’ beach thoughts may drift to the magic numbers of bank capital ratios. I wonder why the financial system relies so much on debt. Loans and bonds are poorly designed for their primary economic purpose – investment.

This observation may sound shocking. Interest-bearing debt is considered totally normal. Financial theory unquestioningly treats risk-free debt as the standard instrument. Savers usually compare all investments to a similar standard: safe bank accounts which pay a steady interest rate.

But a little reflection on the real economy shows that the typical debt arrangement is an unfortunate holdover from a more primitive age.

To start, loans carry a maturity mismatch, because temporary debt funds permanent investments. Depositors can take money out of banks, banks can pull lines of credit and loans are supposed to be repaid or refinanced at maturity. But the factories the credit finances cannot then be unbuilt. The research cannot be undone and the people cannot be untrained.

The most important problem with debt is the so-called economic mismatch: the interest payments on loans vary much less than borrowers’ cashflows. Temporary difficulties can lead basically sound companies to skimp on economically valuable investments, or to default. Banks are supposed to be able to absorb the losses from defaults. They charge riskier borrowers higher interest rates, a burden which makes default more likely. They also have a hierarchy for taking losses. Shareholders lose out first, followed by holders of subordinated debt. In most countries, the government comes to the rescue when losses get really large.

The arrangements are complicated and uncertain – thus the debate over how much capital banks need. The problem, though, is largely created by the duality of loans: either good or bad. If borrowers’ payments were more flexible – lower and higher depending on economic conditions – banks could have financial structures which were both simpler and sounder.

What is needed? Financial instruments which have no maturity, which are protected from inflation and which have variable payments. There’s nothing fantastic about that wish list. Common shares tick all the boxes.

Then why don’t common shares, or something like them, dominate finance? Well, the disadvantages of debt are clear, but it has one crucial advantage: a crude but clear duality. It is easy to tell whether counterparties are living up to the loan terms, so strangers can deal with each other relatively easily.

In contrast, equity only works if the companies that receive the funds can be trusted to make fair judgments on how much to pay investors. Within families and other tight-knit groups, the tug of loyalty and the desire to avoid shame promote the necessary honesty. Much more is needed for shares in enterprises run by strangers to be trustworthy: bureaucratic competence, effective governments and powerful auditors.

Today’s developed economies meet those requirements, but they still rely extensively on debt.

The refusal to relegate this obsolete tool to the dustbin of history helps explain the peculiar vulnerability of modern economies to financial distress. With a more resilient financial system, it would not take more than five years to recover fully from the failure of a single big bank.

This abridged article is taken from Reuters.