The Miraculous Exchange of Free Conversion

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exchALMOST everyone agrees: before the financial crisis, banks were hooked on debt. In 2007, a year before its failure, Lehman Brothers held equity (the money shareholders put into the business) worth just 3.3% of its balance-sheet; virtually all the rest was financed by borrowing. Leverage is an elixir that makes profits soar when times are good, but magnifies losses when the economy sours. Since the crisis, regulators have cranked up their supervision of banks and ordered them to hold more equity and less debt. A new proposal would tweak this model, making banks safer using the discipline of the market rather than the heavy hand of the state.

Banks like debt for several reasons. First, it is cheap compared to equity: banks’ creditors charge relatively little because they know they are likely to be bailed out if the bank fails. Tax breaks for interest payments make debt cheaper still (see this week’s briefing). And unlike equity, issuing it does not entail any dilution of control. But regulators prefer equity, which can absorb losses in downturns and thus ward off bail-outs.

Read more at the ECONOMIST