The current approach to solving the banking crisis is to put more government money into banks. The problem with this approach is that it creates fear of government meddling in the operational and financial decisions of the banking sector. The capitalist system can only survive if two conditions are met: managers are willing and capable of maximising shareholder value.
The problem with government control is that at least the first condition is unlikely to be met. Governments and politicians care about stakeholders not shareholders. For example, David Axelrod, Chief of Staff in the Obama administration, stated on January 18 that "Barack Obama has a strong message for bankers: start lending again". The fact we ended up in the current crisis because of government encouragement to make bad sub-prime loans to people who could not afford it, seems already forgotten.
In short, government control or ownership represents bad corporate governance from the shareholders' point of view. The result is that, although government injections of new capital increase the book value of equity, the market value of equity may actually decrease as a result of collapsing stock prices after the announcement of the government "help". The result is that bank stocks end up in a death spiral.
The alternative, putting more private capital into banks may also be badly received by capital markets as it may be interpreted as a bad "signal" that the bank is in trouble. Unless existing shareholders buy all the newly issued equity, such a negative signal means that banks that are [wrongly] perceived to be bad are forced to sell undervalued equity to new investors, which dilutes the interest of current stockholders.
So, the solution should be to issue equity to private investors without giving a negative signal. How to do this? Perhaps the world should get some inspiration from the Belgian tax reform of 1982, when the Belgian Government introduced a law allowing companies to deduct the cost of equity (estimated at 13 per cent) of newly issued equity from its corporate taxable income for the next 10 years. The rate of 13 per cent was based on the prevailing rate of interest on corporate debt in 1982. At the same time, investors were allowed to deduct up to €1,000 (Dh4,620) of investments in Belgian stocks from their taxable income. As a result more companies issued equity in 1982 than during the previous 13 years and the Belgian stock markets rose by 50 per cent above the Morgan Stanley World Market Index.
Let's think about a similar global tax reform. First, end the tax subsidy to debt financing by making the cost of equity tax deductible. For example, every company should be allowed to take a charge against the book value of equity, at a rate tied to the corporate borrowing rate, for example five per cent. A similar law already has existed in Belgium since 2006. This will take away the tax advantage of borrowing money. This means more bank corporate clients will be interested in equity issues, which will encourage deleveraging without negative tax consequences. At the same time, one major advantage of borrowing relative to equity issues will disappear for banks as well, encouraging them to borrow less. This tax law change should be permanent.
Second, give a tax deduction or a tax credit to anyone who buys newly issued bank shares in 2009. This will increase the demand for bank shares: in some ways, banks have now obtained a licence to sell tax credits to investors. Note that this part of the tax law would be applied only to equity issued in 2009, to encourage immediate action.
Such a tax measure will have three major advantages over the current approach of putting more taxpayer's money into banks. First, the government will not become a shareholder in the bank, preserving the benefits of private ownership. Second, by tying equity issues to tax credits, the negative signal will be avoided. Banks that issue equity will be considered as banks that sell tax credits, not banks that are in trouble. As happened in Belgium in 1982-1983, stock prices will rise around equity announcements, rather than fall. Third, the critique that the taxpayers are bailing out the banks would be avoided. Of course, the government will help finance the bail-out by giving tax reductions, but the cost of these reductions is going to be smaller than the costs of the guarantees and subsidies that the governments are handing out right now.
Will such a change in tax laws reduce banks' incentives to borrow? We would hope so, although we are still concerned about one major issue: in spite of the Nobel prize-winning contributions of Merton Miller and Franco Modigliani, who have shown that without tax benefits, there is no reason to prefer debt over equity, there seems to be a widespread belief in banks that debt is cheaper than equity, regardless of the tax treatment. This is, I believe, a result of the obsession with earnings per share and return on equity as corporate objectives. It is true that borrowing increases earnings per share and expected return on equity, but it makes earnings more risky, so that the present value of earnings is independent of capital structure. So, besides tax incentives, we also need to abolish executive bonuses tied to earnings per share and return on equity, and instead make sure that executive compensation is tied to long-term shareholder value.
- The author, Theo Vermaelen, is a professor of finance, Insead