One such friction is the variability of default costs in the bankruptcies of borrowers – a particularly worrisome factor in times of economic crisis. Another risk resides in what, viewed in the near term, is a benefit to both lenders and borrowers: banks’ ability to deduct debt from the interest income they get from borrowers.
Virtue Versus Viciousness
The way Strebulaev describes it, a virtuous cycle looked at in terms of individual companies has grown vicious in terms of systemic risk. To show how the system rewards overleveraging, he compares two hypothetical banks, one with relatively small amounts of debt and the other leveraged to the hilt.
The bank with the heavier debt load will be able to get a bigger tax deduction. If it so desires, it can use that extra cash to charge lower interest rates to customers – and win a bigger market share from the more prudent bank.
Thus, the system packs a strong incentive for banks to borrow. While that provides a big advantage to companies in terms of the cost of capital, it spawns a huge economic risk for banks, particularly in an economic crisis. “Even if a small number of firms default, it can tip the bank into distress because they’re over-levered,” says Strebulaev. “The solution is for firms to borrow less from the bank, because it will take a much larger shock for the bank to get into stress. That is what I mean by supply chain.”
Yet CFOs earn their keep by improving the lot of the companies they work for, not by saving the system as a whole. What can individual finance chiefs do to keep funds flowing to their firms?
By choosing banks that will be in a position to re-up their revolvers in the face of a recession or provide relatively cheap lending when times are good, according to Strebulaev.
First, they should gauge the relative long-term stability of a bank by checking out two kinds of publicly available data: the banks’ mean Tier 1 core capital and its Tier 1 leverage ratios. “If the bank is at the minimum Tier 1 capital, that means that if there is going to be a recession, that bank is going to be the first to go under,” he warns.
Even though it may cost a lot in extra fees and take time, finance chiefs should also establish relationships with a number of banks, rather than rely on just one. That’s especially true for companies with volatile cash flows and ones with fortunes that generally track those of the broad economy, according to Strebulaev. (Anti-cyclical companies, like firms that sell gold, would have less need for such diversification in a crisis.)
Such companies would do well to look deeply into the health of their banks to prevent a loss of access to funds when they most need it, Strebulaev advises. Referring to a well-known bank failure, he said, “let’s say you had a credit line revolver with IndyMac back in the crisis. What would have happened to your commitment? Most likely it would have gone away.”