On Thursday, the New York Times published a piece that needs to be strongly rebuffed. The story addresses the amount of debt being incurred by businesses, particularly banks.
The author writes, “Sure banks pay taxes, but they pay a lot less thanks to a giant and underappreciated distortion in the tax code ... [which] makes the financial system and the economy more fragile ...”
Suggesting that banks borrow money to decrease taxes is one of the strangest suppositions made during the past few years by a media source unfriendly to the banking industry. This comment makes no sense for a variety of reasons including the fact that interest expense, in fact, decreases dollar profits, while the issuance of stock does not (although earnings per share is affected by new stock issuance).
Corporate executives are always trying to create the perfect capital structure by tweaking the composition of debt and equity on their balance sheet. This is a very complex undertaking because so many issues impact the determination.
Lets get basic: Corporate Finance 101, if you will. The least expensive form of financing is short-term debt. The one month London Interbank Borrowing Rate (LIBOR) is .22 percent. A highly credit worthy corporation can borrow funds from a bank at, say, 50 basis points over the LIBOR rate or .72 percent.
The most expensive form of financing is stock issuance. Investors who by stock expect a rate of return of about 15 percent plus and price newly issued stock to reflect this target. Therefore, a borrower, if he has a choice, would always opt for debt.
But, there are other factors at play that influence a borrower's ability or desire to select debt over equity. Lenders, rating agencies and regulatory agencies affect the corporate decision to obtain new capital. If a company wants to borrow, but creditors believe the company’s leverage (debt versus equity on the balance sheet) is too high, borrowing will be difficult and/or significantly more expensive. If a company wants to maintain a specific credit rating at Moody’s or Standard & Poor’s (the top two rating agencies), borrowing from a bank may not be ideal because new debt would create too much leverage for the desired rating objective. Regulators, especially with banks, have a huge amount of influence on bank capital structures and often demand the infusion or more equity rather than debt.
There are many other issues that affect these decisions including the balance between assets and liabilities, the risk in the company’s asset portfolio, etc.
Back to banks. Suggesting that interest expense should not be tax deductible because banks would borrow less is an outrageous proposal and one based upon an inability to comprehend the basic elements of corporate finance. Banks do not borrow because debt is tax deductible. They borrow because the overall cost of debt compared to equity is lower. The deductibility of interest has an impact but it is not the overwhelming determinant. As mentioned above, a bank’s decision to maintain a particular capital structure is based upon many other considerations.
Other absurd comments in the piece include the following:
1. “More debt ... makes companies more vulnerable to bankruptcies ... [and] to panics.” Sure, if a bank or any company is over-leveraged, it is at risk. The proper capital structure decreases cost, while at the same time, provides the right amount of security and helps in achieving compensatory shareholder returns.
2. The deducibility of bank debt interest is not a “loophole.” It is baked into the system. The odds of eliminating this feature are about equal to eliminating the deductibility of mortgage interest for all homeowners (it may be possible to pursue this for high income earners).
3. “Banking is a highly leveraged industry ... the [interest deductible] tax break makes debt cheaper and encourages banks, at the margin, to gorge on more.” If you assume total irresponsibility by banks, regulators, rating agencies, boards of directors and shareholders, this comment might hold water. If you do not, it is nonsense.
4. “Partly because of the tax code distortion, corporate debt is over-consumed by the bank’s customers.” Another inane statement. Investment banks do not establish borrowing rates; investors and markets do so. Investment and commercial banks do not force companies to borrow or issue equity. Rating agencies and funding sources have the real power.
5. “ ... the banking sector accounts for a bigger proportion of gross domestic product and corporate profits than it otherwise would.” I have never heard this observation before nor do I think it matters. Banks facilitate trade. They prosper and grow with the economy. Specific financial techniques occasionally present systemic challenges, but generally a large productive banking system is good for the economy and American workers.
6. “ ... having a bigger finance industry than necessary wastes resources ... [banking is] not an end unto itself.” If this means banks are not entitled to earn profits, I think the suggestion is idiotic.
This article is uninformed and inflammatory. Any sophisticated observer of the banking industry, even if he is concerned about banking influence on our society, should find the populist perspective of the author laughable. The Times should discourage its journalists from dressing up as economists.