The problems with debt-hungry banks

April 4, 2014, 6:50 PM UTC
Wall Street’s bullish appetite for debt

FORTUNE — Regulating banks is the Gordian knot of today’s financial system. There is no shortage of bank regulation proposals. Most are about constraining the amount of debt banks hold either by making capital requirements stricter or by forcing the banks to hold special securities, such as contingent convertible notes, that convert into equity in times of distress. One challenge with all these proposals is that bank balance sheets are so complicated, it is impossible for regulators to untangle them.

My recent research into why banks crave debt points to a simpler solution: reduce the tax penalty banks pay for having equity.

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Banks do indeed crave debt, and most are highly indebted, which means that even minor losses can lead to financial distress. If you buy a $100,000 house with a down payment of only $1,000, then a decline of just 1% in the home’s value will put your house underwater. This is a rather scary margin of safety and is why individual households and non-financial firms don’t, as a rule, overwhelmingly rely on debt when they raise funds. U.S. public firms, for instance, are on average financed only 30% with debt. The rest is equity that serves as a buffer to ride over bad shocks.

What about banks? Unlike Main Street firms, 90% or more of U.S. bank assets are financed with debt. Thousands of banks have more than $9 of debt for each dollar of equity. When the next recession hits, these banks will be vulnerable to failure, and we could again face a financial meltdown.

Financial institutions are tightly linked in today’s world, and the fall of one bank can lead to instability in many other highly leveraged banks. Limiting excessive bank leverage could ease risks to the financial system, but it is also important to understand why banks hold so much debt in the first place. After all, Main Street firms try to stay away from using too much debt, for they know that excessive debt spells trouble.

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Over the past couple of years, a Stanford University Ph.D. student, Will Gornall, and I have been working on this fundamental question.

One major force that we have identified is the tax benefit of debt. A twist of history means that the interest paid on debt is deductible from corporate taxes, while the dividends paid to equity are not. This tax policy favors debt and bank borrowing. Researchers have been studying the impact of taxes on corporate debt levels for a long time. However, the focus has always been on non-financial firms. When we apply the same analysis to banks, we find that banks have an even stronger incentive to issue debt. Banks act as conduits of funds between savers and borrowers. Say, if a firm borrows $100,000 from a bank at 5%, the bank first needs to raise this money elsewhere. The firm pays $5,000 interest a year, but for the bank $5,000 is actually an interest income, a profit. The bank has to pay tax on that income. That is, unless the bank deducts all of it because of its debt. What happens is that it is good for banks to lever up to the neck because then they can deduct interest they have to pay from that $5,000 income.

Also, those banks that don’t have much debt have to charge higher interest to their borrowers (because they can’t deduct that interest any longer), making borrowers unhappy — not only because interest is higher, but because it basically offsets any tax benefits that borrowers can get. Tax benefits, studied for so long, originate in the financial intermediary system of the economy, not in non-financial firms. This is why banks are highly leveraged.

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Banks are being given a massive tax break if they borrow and become risky. Thousands of pages of regulation limit bank borrowing, and yet the tax code pushes banks to borrow more and more. This Kafkaesque structure has no serious economic justification. Fortunately, the fix is easy. Equalizing the tax treatment of debt and equity could slice through this Gordian knot and untangle bank financial structure. The government could end the subsidy for corporate borrowing while simultaneously reducing corporate tax, thus making this tax neutral from the public revenue perspective. An alternative way is to equalize equity and debt by adding tax benefits to equity. The latter was recently partially implemented by Belgium. The effect: Firms and banks there now issue less debt and have safer capital structures.

Both Republicans and Democrats have talked about tax reform and the value of broadening the tax base and eliminating loopholes. This large and harmful tax distortion has been off the table — it needs to be part of the discussion. Ending the tax discrimination against equity would give us safer, less leveraged banks and reduce the risk of another financial crisis.

Ilya A. Strebulaev is a finance professor at Stanford University’s Graduate School of Business and a research associate at the National Bureau of Economic Research.