If people and companies behave rationally, then the crisis of 2008 would not have happened. Lehman Brothers bankruptcy occurred because of too much bank debt. Economists have found the key solution for credit institutions.
Since the crisis began, economists have criticized banks that are too carried away with borrowed money. The most striking example of the credit "addiction" was the actions of Lehman Brothers, which went a bankrupt in 2008. Since 2001, the management of this financial giant used accounting tricks to borrow but, at the same time, do not impair its financial performance and to keep a high rating.
By the way, this issue also applies to the inexperienced Forex traders who due to wish of great profits often use unnecessarily high leverage (it’s also a sort of borrowing).
In order to hide the actual level of the balance owed before the release of the Lehman Brothers’s quarterly report, the bank transferred problem assets to its office in London. That office, in turn, made a deal with another company, pledging to buy the assets back in a short time at a higher price.
Key points of the bubble.
The money from this transaction the bank used to pay off prior commitments. As a result, for official reports the level of leverage (ratio of debt to equity) was maintained at an acceptable level and the financial position of the bank seemed stable.
However, at the beginning of the next quarter, the bank had to borrow money again to buy its own assets and then sell them again. Financiers were so addicted to this "drug" that before the crisis the cost of masked bad assets was 50 billion dollars.
Lehman Brothers wasn’t the black sheep in the herd - so were all the largest banks in the world. Before the crisis, most banks had very high debt burden: the ratio of debt to equity in some cases reached 30 to 1.
After Lehman Brothers went bankrupt and caused paralysis of financial markets around the world, the idea of a high debt burden on banks was discredited. Regulators have introduced more stringent rules of capitalization of banks, limiting the level of borrowing.
They did it for nothing, think economists of the University of Southern California. In their study, they argue that the high debt burden of banks is the best solution. However, only in the case when several conditions are met. First, market participants are rational (and not as financiers of Lehman Brothers), and, secondly, there are no transaction costs and taxes.
Here's how the behavior of banks could look in a perfect world.
Credit institutions would choose a high debt load, even in the absence of tax incentives that make borrowing the best way to finance.
Increased competition would lead to a “compression” of liquidity in the banking system, and thus would increase the optimal leverage ratio of the bank. Now in the advanced economies the best value for leverage ratio is 1.5 (60% debt and 40% equity). If it goes beyond that, the organization goes into the category of "financially unstable".
It would be more difficult to develop for a shadow banking sector. Now, when conventional lending institutions faced with regulatory restrictions on borrowings, finance migrate from the regulated banks to the unregulated shadow banking sector.
Banks would have structured their assets more safely. Then the chances of the emergence of new financial collapse would tend to zero.
When critics require banks to work with the least amount of debt, bankers say in response that they will have to pay a higher return on the additional investment in the capital. This will result in a rate increase on loans issued, and this in turn will slow down economic activity and GDP growth.
The truth lies somewhere in the middle between hard critics and disgruntled bankers.
On the one hand, the bank with a larger share of its own funds significantly reduces the risks. But, on the other hand, if it does not have obligations to investors, the chances that it will go to unreasonable risks increase. The need to return the borrowed funds leads to strengthen discipline and does not allow the banker to take many risks.
Researchers from University of Southern California do not take into account another important detail - the ideal world and ideal economy with the ideal behavior of its subjects simply do not exist.
Graphics: Global crisis – How it was
