Hillary Clinton’s Plan Will Hurt The Banking System — And Will Hurt All of Us

**I should preface with the fact that if I had to register with a party it would be the democratic one.. and I’ll probably be stuck voting for Hillary this year. So please don’t take this post as anything beyond a criticism on her view on banks.

Banks are really important. They’re SO important that sometimes we call them “Too Big to Fail.” They‘re big enough that if they failed our whole economy could go (most definitely would go) down with them.

And so they’ve gotten a lot of attention. The problem is the democratic party too often frames banks as evil institutions aimed at taking money from the poor. And while banks often do bad things — they are not evil (mostly).

Bernie Sanders’ plan is to “break up the banks.” Which really doesn’t actually mean anything. You should just dismiss the whole idea. Banks need to be large — if they weren’t we wouldn’t trust them to hold our money — they couldn’t operate at scale, interest rates would go way up and the poor would get hurt the most.

If you are mad at me for saying this, please ask yourself if you know what “return on equity” means for a bank. Or think in your head: “Do I know what what Basel III is?” If you do know, please proceed to curse me out. If you don’t know what those terms means, stop being mad at me and realize you, like Bernie, don’t get how banks work. Sorry.

So What’s Hillary’s Plan?

She wants to limit the amount of debt banks can hold on their balance sheet. She wants banks to have to use their own equity capital to finance their business. And this sounds like it makes sense. Why would we let banks take on excess risk if their failure could hurt innocent Americans.

Some might argue that “markets correct themselves and banks can regulate their own risk.” But if you look at churn within the S&P 500 you can see proof that if left to their own devices, big companies fail so some regulation probably makes sense. Lehman Brothers was the first time that everyone had to admit: “okay… at least some regulation is needed.”

Equity Capital Versus Debt Capital

What’s the difference between equity capital and debt capital? If I “raise equity capital” it means I’m giving you a % of my business for $X. That is really painful, and the more I “raise equity capital” the more I “dilute” everyone else who already had equity. And so if we used to split $10 of profit 10 ways (and each earn $1) we now have to split $10 of profit 20 ways (and each earn $.5).

Raising equity capital in that example cost us $.5! See how that could be seen as “expensive capital?” And banks think a lot about their return on equity. “How much do we make in profit for every dollar of equity?”

Raising debt financing is considered “less expensive” than raising equity financing, because instead of splitting up the profits across more shares of the business — it’s essentially just paying a small obligation before the profits after that “interest expense” are paid off. In general, this cost less to the equity holders than dilution does.

The problem is that those interest payments are an obligation. And so in good times, only using debt capital is the most profitable thing a bank can do for its equity holders. But in bad times, if you have an obligations with no cash to pay them, it could crush everybody and send a business into bankruptcy. And so banks and the government must play a game of “how much liquidity or equity capital must banks have to make sure they can meet their obligations and not go out of business?”

Hillary is not asking for banks to take on “no debt.” But she wants to tax them based on the debt they take on to make it less attractive to leverage themselves (run their business using debt capital instead of equity capital) to discourage them from doing is.

But Some Regulation is Good, right?!

Yes, some is good, and we already have some. Banks are regulated by two liquidity mandates:

“Liquidity Coverage Ratio”: makes sure banks have enough in liquid assets at any given time to live through a 30 day market crisis. This is the amount of time the government believes it needs to take emergency action if needed.

This is measured by assessing Level 1 assets (really liquid stuff like government bonds) to Level 3 assets (lest liquid stuff that’s harder to sell) to figure out if they could get enough cash quickly to meet their debt obligations if they had to in a short period of time. Level 1 assets get measured up to 100% of their value, Level 2 assets get measured up to 50% of their value (I think??) and so on…

The second mandate is the Net Stable Funding Ratio which essentially makes sure that long-term assets are funded by long term and stable funding sources.

And Banks Have Already Taken the Hit

These new regulations, amongst others, have made it hard for banks to continue lending in many of the markets they used to serve. The reason is it’s expensive for them, or they have to hold on to more low earning assets to do so, and this kills their profitability.

Banks target a return on equity (“the amount of net income as a percentage of shareholder equity”) or 10%. But even today they are only earning ~8%. This means they are not hitting their targeted profitability.

If they start getting taxed for using debt capital it’ll hurt their ROE even further. And two bad things happen that hurt us consumers as much as they hurt the banks.

Why Do Banks Hurting, Hurt Me?

Here’s why:

(1) Remember how we said banks are really important? Well.. if they become less profitable, the people who own them make less money. And those are really smart and qualified people, and the smartest people will start leaving these banks and move to hedge funds or private equity firms or other shadow banking institutions that face less regulation and where they can make more money.

Major League Baseball players make more than the CEO of Goldman Sachs. What do you think is a more important job? Managing our economy? Or Hitting a baseball? Why does Lloyd Blankfein get more shit than Bryce Harper for how much he makes?

Banks becoming less profitable means the management teams make less money, meaning they leave, meaning banks become run by less qualified people and then we are really in trouble. Because we’ll have subpar people running the most important part of our economy. Banks will get negative selection bias in who they can recruit, because the best and brightest won’t want to go with them (this is the same problem the gov’t has when hiring).

(2) Risky financing practices will move outside the banking system (which is regulated by the government) and move into the shadow banking system (non-FDIC insured financial institutions).

The banking system is just like the Cornell Greek System:

At Cornell, fraternities started doing stupid stuff like drinking too much and doing drugs. So Cornell started cracking down on frats, kicking them off campus, and not letting them throw as many parties.

So the Cornell students started partying out in Collegetown in private homes that could not be “regulated” by Cornell. It’s not like kids stopped drinking and partying and doing drugs, they just did them in places less safe with no oversight.

Just because banks aren’t able to make investments that hold risk, it doesn’t mean borrowers stop needing to borrow.

So these new shadow banks have taken over a lot of the businesses banks used to manage. Blackstone now manages $344 Billion in assets. Blackstone had $47B under management in 2008. Proof they are taking on a lot of the business banks used to be responsible for. This should be a huge red flag saying that the money and risk is still there, just not in the banks — and in fact in even less regulated places than before! Holy shit!

So the financial system has arguably become even riskier.

(3) Borrowers get screwed. Because there are less competitors, and because it’s expensive for banks to lend, they have to increase their prices or not compete at all. A combination of less competitors and a higher cost to lend means that us borrowers have to pay more when trying to access credit.

The small business owner trying to get off the ground, or the new married couple looking to buy a first home are all getting screwed by liquidity crunches. They are no longer able to borrow the money they need to achieve their dreams and in an extreme case pursue the American dream.

Hillary’s Plan Hurts Banks, and Thus Hurts Us

Banks are a core part of our economy. They provide liquidity, they are a utility, they hold our money for us and they keep us safe. They make us loans when we need the money and they let us store our cash when we’re ready to save and invest.

If we make their lives harder, they’ll have trouble functioning and non-banking institutions will take the baton, and do riskier, scarier and less regulated things with it. Talent will flow out of the banking system, and new “Too Big to Fail” institutions will take shape in different forms.