(June 12): Smoothing the economic catastrophe generated by Covid-19 has led to intense discussions on whether the banking sector is an effective channel to inject financial oxygen into the economy.
Banks know how to provide needed credit to companies and individuals, and governments contact bankers daily. Societe Generale CEO Frederic Oudéa, echoing former Goldman Sachs boss Lloyd Blankfein’s “we are doing God’s work” statement, proudly affirmed: “We are the doctors of the economy.” It is amazing that a tiny vicious virus has unexpectedly offered banks the opportunity to regain a reputation lost in the Global Financial Crisis (GFC).
Two questions frame the general debate: Is it appropriate to shield banks and provide them with financial immunity (which all dream about today); and should banks be prevented from paying dividends and making share repurchases during this extraordinary time? We aim to provide answers to both, informed by scientific evidence, of course.
The answers are complex. What is not, however, is that banking boards, bearing fiduciary responsibility, will need to decide how enthusiastically their institution will embrace the call. Directors need to balance profitability and risk with the explicit call for broader corporate responsibility. They also will need to adjust their short-term responses with their bank’s long-term prospects, including their solvency. Banks will thus not reply uniformly, their boards retaining the final call. Requisitioning banks is not a solution either; it kills them instantaneously.
A second principle worth remembering is that government-directed lending typically leads to distortions which, in time, generate asset bubbles and serious unintended consequences.
For example, at the origin of the GFC was a US government policy that every American should own her, or his, house, even when not having the means to be an owner. Banks are, like all of us, full of intelligence — some of it good, the rest of it more wicked.
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Banks have a record of engaging in “window dressing” and “profit pumping”. The Wells Fargo “cross-selling” scandal is evidence of this. Australia’s Royal High Commission found plenty of it too, over many years, with regulators lacking vigour in detecting it. Recent research in the US involving the Community Reinvestment Act of 1977 (CRA) has further improved our understanding of the subtle, yet material, practices at play.
CRA is a case in point. The legislation directed banks to improve capital access in US lower-income neighbourhoods. Banks, not supported by the government, had to compensate for CRA loans the government pressured them to make, which they judged to increase their risk and reduce profitability.
They thus exploited their relational banking capabilities to increase lending to firms with which they enjoyed favourable credit histories. These borrowers were induced with low credit offers, reducing the bank’s overall short-term risk and, unfortunately, profitability. Banks convinced “safer” clients to take on more debt and engage in “value-creating” share repurchases and mergers & acquisitions.
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These strategies, on average, proved sub-optimal and riskier than all expected. The long-term results were very negative: more defaults reduced profitability, and ultimately caused more considerable distress, including in lower-income neighbourhoods, and the banks participated with full force in the government’s programme. Banks were obliged to abstain from share repurchases, which was precisely the action they advised upon their “safer” corporate clients.
The “helicopter money” scenario envisaged today sees banks injecting substantial money into the economy. Given the size of the problem, banks risk assuming an amount of credit they would not have committed to as self-standing institutions. Banks are thus requesting governments to shield them. If government guarantees will be partial or remain uncertain until lenders default — many are expected to — banks will find ways to cope, with even worse implications for the economy.
To avoid this, governments must guarantee the risk that banks will find commercially unjustifiable. Excessive directing by the government will backfire. No one wishes to see bank runs and bank failures, prompting a “second wave” GFC.
Our second question centres on whether banks should pay dividends during the Covid-19 pandemic. This question may be misguided. The CRA study suggests that the share repurchases by companies receiving CRA loans outweighed any repurchases banks might have considered. Besides, the dividend issue is not the most critical in this debate as bank shareholders are mostly diversified investors (for example, Blackrock and Fidelity). They achieve liquidity by selling shares. Given that bank shares have plummeted, share repurchases may be the signal to instil vigour and also trust in the banks.
Banks’ usage to channel financing to the economy thus requires banking boards to be clear about what mission they will pursue during this pandemic and for how long. The boards that will be genuinely willing to be socially oriented will risk their solvency in support of their clients. The latter was the choice MDs made during the current Covid-19 crisis with the consequence that too many of them died.
The writers are both Insead faculty members. Massimo Massa is Rothschild Professor of Banking and Ludo Van der Heyden is Chaired Professor of Corporate Governance
