Equity Capital Of A Bank As A Call Option On Bank’s Assets11 August, 2011, 19:56. Posted by Zarathustra
Tags: Banks, Financials
We now find ourselves bizarrely in a potentially nasty European debt crisis and banking crisis. So today I want to talk about failed banks.
Banks are typically a highly leveraged business. The equity capital of a bank is typically just a fraction of its entire capital structure. Banks are mostly funded by debts, as you can imagine: customers deposits and others. Liabilities of banks are explicitly or implicitly guaranteed by governments or central banks up to a point. Customers deposits, for instance, are usually guaranteed by some sort of deposit insurance, and the 2008 financial crisis shows us that many governments are quite happily willing to take on banks’ liabilities onto governments’ balance sheets (which in turn turned a banking crisis into a sovereign debt crisis). As a result of that, banks seem to have very low costs of debt funding.
At the height of the 2008 financial crisis, Knight Vinke, an asset management firm, has famously had some serious debates with HSBC’s management on how to run HSBC. Seriously I used to think that they were wasting everyone’s time: if you genuinely hate HSBC, just sell the shares. I think they did sell the shares eventually. But in the process of these debates, Knight Vinke asked two professors at London Business School, Viral Acharya and Julian Frank, to consider some questions. The two professors replied with an interesting letter.
Regarding a failed or near-failed banks in bad times, they replied (emphasis mine):
The flat cost of debt is not a reflection of the low business risk of the bank’s assets but largely a reflection of the value of the Central Bank guarantees over some or all parts of bank debt, an issue we return to in some detail below. This flat cost of debt encourages a high level of leverage as is typically present in bank balance-sheets. This makes equity into a virtual “call” option on the underlying assets. Given this view, it is clear that as leverage increases, the equity of the bank resembles more and more an “out-of-the-money” option on bank’s assets. At these high levels of leverage, a small change in bank’s asset value will cause much more than a one-for-one change in bank’s equity value. In particular, a small business loss can wipe out a significant part of equity value (as witnessed recently). Put simply, with high leverage, equity is a highly levered bet on bank’s assets.
This view of equity is important because it implies that bank equity will have a low beta on its assets (and thus on the market) in good times when the equity option is essentially “in-the-money”, but a much higher beta in bad times when the option is out-of-money. A beta of (say) 1.0 to 1.3 for bank equity estimated in halcyon days significantly under-estimates the beta in a tempest, and by implication, the equity cost of capital. It is worth repeating that this high cost of equity applies to both the bank’s existing equity and any new equity although the latter may be especially expensive in bad times. As a result, banks and the market have tended to underestimate the cost of equity.
Welcome to the European sovereign debt and banking crisis of 2011.