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Beware of Banks with Too Much Debt

The ratio of debt to assets for U.S. banks has ranged from 87 percent to 95 percent over the past 80 years.

“History does not repeat itself, but it does rhyme,” says Ilya Strebulaev, quoting a line attributed to Mark Twain as a way of answering the question of whether the next financial crisis would look like the one that began in the fall of 2008.

Strebulaev, an associate finance professor at the Stanford Graduate School of Business, was making the point in a recent interview that although the next inevitable collapse of the financial system would be different from the events following the collapse of Lehman Brothers, it would have some similarities.

Inevitable? Yes. To be sure, the exact time and cause of the debacle can’t be predicted. But a big shock to the global financial system – like the collapse of a nation like Cyprus, say, or the bursting of a real-estate bubble – is sure to trigger devastating reverberations because “the banking system has not been really made stable,” says the professor, who directs the school’s executive education program on “The Emerging CFO.”

Because the system hasn’t been strengthened enough by rule-makers in the wake of the Great Recession, it won’t be able to withstand a cataclysm, he reasons, noting three basic sources of weakness: capital requirements under Basel III that aren’t “as stringent as we believe they should be”; increasing correlations among the various assets that banks hold, making them especially vulnerable to volatility in the values of those assets; and misguided bank corporate governance that has aligned the incentives of managers “such that they prefer to risk or to gamble.”

Strebulaev, co-author of a recent working paper that sees the current distribution of debt from bank depositors to banks to corporate borrowers as a “supply chain,” thinks CFOs need to become particularly alert to exactly how fragile their lenders are.

The long-term indebtedness of U.S. banks puts them into a precarious position, he thinks. Their average leverage, gauged as the ratio of debt to assets, has ranged from 87 percent to 95 percent over the past eighty years, according to estimates based on historical Federal Deposit Insurance Corporation data.

Until now, however, corporate finance executives in the process of trying to raise money from banks haven’t cared much about knowing about how or where banks got their funds. What was essential to know about were the interest rates and the conditions attached to a specific loan.

For a small company negotiating a single loan, that still might be enough knowledge, according to Strebulaev. But for larger companies, especially ones seeking to cultivate a relationship with a bank, “you need to know the source of financing,” he says.

That’s because banks, in their roles as intermediaries in the debt supply chain, are increasingly sensitive to “frictions” in their financial relationships with their creditors (bank depositors and other lenders) and commercial borrowers. The main reason for their sensitivity is that banks’ excessive debt loads give them less flexibility to deal with the increased volatility in the rest of the supply chain, according to Strebulaev.

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