World Economy

Markets Don’t Trust Banks

Markets don’t appear to believe that banks are much healthier.Markets don’t appear to believe that banks are much healthier.

Almost a decade after a crisis that nearly brought down the global financial system, markets still aren’t showing much confidence in banks. It’s a troubling phenomenon that US and European leaders ignore at their peril.

It’s understandable that, after years of wrangling and thousands of pages of new rules, regulators might want to consider their mission accomplished. They have changed the way they supervise the system, reorganized derivatives markets, subjected banks to regular stress tests and instituted myriad new reporting requirements. To bolster banks’ loss-absorbing capacity, they have required hundreds of billions of dollars in added capital, columnist Mark Whitehouse wrote for Bloomberg.  

Yet, as former US Treasury Secretary Larry Summers has taken to pointing out, markets don’t appear to believe that banks are much healthier. This is evident in how they value equity—that is, the amount by which a bank says its assets exceed its liabilities.

Back in the early 2000s, investors often paid $2 or more for each dollar in book equity, a sign that they trusted banks’ accounting and expected to reap significant profits. Now, though, even after the mini-boom following Donald Trump’s election, they’re valuing the largest five US banks at about $1.16 per dollar of book equity, and the top five European banks even less.

Declining profitability is one explanation. Smaller returns, though, can’t explain the whole gap. Trust matters, too. After a crisis in which supposedly well-capitalized institutions suddenly found themselves in distress, it stands to reason that investors wouldn’t have much faith in the numbers banks produce—particularly given how opaque the accounting tends to be. Investors might also have come to recognize what Mervyn King, the former head of the Bank of England, calls “radical uncertainty”: It’s just impossible to foresee and assign probabilities to all the things that can go wrong with a bank.

What to do? Simplifying regulation could help. A lot of the most burdensome rules arose because banks have been so resistant to the elegant approach of sharply increasing loss-absorbing equity. Even with all they’ve raised in recent years, the largest banks’ equity amounts to about 6% of total assets on average (measured according to international accounting standards). If they had closer to 20%, enough to weather an unforeseeable disaster and still be well-capitalized, they would inspire greater confidence and require less supervision.

By making shareholders more fully responsible for losses, the added equity might also create an incentive to unlock value by dividing the largest, most complex banks into more manageable and understandable pieces.

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