Was Debt Ceiling Debate Tip of the Iceberg?

Mark Marich

PDE staff were on hand for “Debt Financing in the Domestic Financial Sector,” a recent hearing held by the Subcommittee on Financial Institutions and Consumer Protection. Their report follows:

Is the recent debt ceiling debate the proverbial tip of the iceberg? It is, at least according to Senator Sherrod Brown. Last week, the Chairman of the Subcommittee on Financial Institutions and Consumer Protection (within the Senate Committee on Banking, Housing and Urban Affairs) said as much at a hearing on “Debt Financing in the Domestic Financial Sector.”

Senator Brown intimated that the core issue was not about raising the debt ceiling per se; but rather, doing something about the debt in the financial sector. “Too many people in Washington seem to have forgotten about the debt that put us in this deep recession, and it is the debt in the financial sector,” he said. Despite the implementation of Dodd-Frank to regulate some of the activities in the banking sector in order to forestall another crisis, Brown called for an examination into what more could be done by further reducing the over reliance of borrowing and to save the nation money it would have to use in bailouts, decreased tax revenues, and new spending programs.

Joseph Stiglitz, Professor of Finance and Economics at the Columbia Business School, echoed the sentiment, “While the Dodd-Frank Bill improved matters, it went nowhere far enough: the problems continue, and as long as they continue, our economy is at risk.”

Three other witnesses testified before the committee:

  • Edward Kane, Professor of Finance at Boston College
  • Eugene A. Ludwig, CEO of the Promontory Financial Group
  • Paul Pfleiderer, Professor of Finance at the Stanford University Graduate School of Business

Reasons for the Debt in the Financial Sector

In his testimony, Pfleiderer outlined two primary reasons why there is such huge debt in the financial sector. First, because the US tax system favors debt financing over equity financing. According to the Stanford professor, the simple reason for this bias is because, in the computation of corporate tax, interest payments are treated as a “deductable expense,” where as payments to shareholders are not treated in the same manner. Consequently, debt provides a “tax shield.” Since companies act rationally, they would tend to use more debt financing as that has a lower tax bill than compared with being funded with less debt. The second reason is because “too-big-to-fail” banks benefit from “implicit guarantees” that the government provides for the banks’ debt. Pfleiderer further stated: “By lowering the risk of holding debt, these implicit guarantees lower the interest rate banks must pay to their creditors and constitute a significant subsidy to the banks on their using debt rather than equity.”

Stating the Case for Continued Reform

In his closing remarks, Stiglitz stated his unequivocal belief that the “economic and financial system is badly distorted.” He sounded a note of caution by saying that it was unwise to rely on the self-regulation or self-restraint of financial markets, as that lesson was learned in the aftermath of the Great Depression, and the decades following World War II.

Kane made a statement on “Distortions in Systemic-Risk Measurement and Risk-Taking in The Financial Sector,” where he intimated that his recommendations for regulatory reform are rooted on what he described as the “ethical contention” that protected institutions and safety-net managers owe to taxpayers. He called for the implicit and explicit costs incurred by taxpayers while supporting national and international safety nets to be measured and promulgated. Furthermore, in order to aid regulators achieve this feat, Kane called for a change in the manner regulators are trained, recruited, and incentivized.

Finally, Ludwig said that though it was the view of many that the weaknesses of the financial sector could be solved through the influx capital, what was rather needed was “balance” – specifically the need to be careful of excess. “So how do we ensure that our regulators and regulations are both serious and meaningful, but not so elaborate that they weigh down banks to the point of dysfunction?” In answering his own question, he suggested the following guidelines:
  • Constant and thoughtful Congressional oversight
  • Ensuring that regulators continue to be top professionals who are devoted to a safe and sound banking system—one that supports prudent innovation and growth
  • Regulators and Congress must avoid waste and excess in implementing rules and procedures
  • Regulators should periodically review their rules to insure that they are both effective and cause the least burden possible
  • In implementing the Dodd-Frank Act and international capital and liquidity rules for global banks, there should be a level playing field.

[Reported by Fertaa Yieleh-Chireh]

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