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Ecuador: Bank Spreads, Taxes, Executive Compensation and Growth

(Cross Posted at Benzinga.com)

One of the distinctive features of banking in scores of developing nations is the very large spreads between the rate of interest they pay their depositors and the rate they charge borrowers.  Academics have frequently focused on the exceptionally high spreads in Latin America in articles published over the last three decades.  Economic theory predicts that these spreads should impose a major drag on development.  The high interest rates charged to lenders should lead to very large “hurdle rates” for prospective borrowers’ projects.  The two obvious implications of high hurdle rates, sometimes discussed in the literature, are that fewer worthwhile investments will be made by prospective entrepreneurs and more of the loans in Latin America are likely to go to high risk borrowers.  High risk investments should be, if financial markets are efficient, more likely to produce higher returns exceeding the hurdle rate.  The standard neo-classical economic assumption is that financial markets are efficient.

The literature ignores two more subtle implications that are likely to be more powerful and harmful.  The neo-classical literature assumes that any problems with bank spreads in Latin America arise from “moral hazard” — which they (implicitly) assume involves only “risk.”  The economists who author these articles routinely ignore the criminology, economics, and regulatory literature on “control fraud,” particularly accounting control fraud.  As George Akerlof and Paul Romer explained in their 1993 article (“Looting: the Economic Underworld of Bankruptcy for Profit”), accounting control fraud is a “sure thing.”  It produces record, guaranteed (albeit fictional) reported income in the short-term.  Given modern executive compensation, the fictional income will make the CEO wealthy and to do so quickly while burnishing his social status and ego.  I have often explained how bank CEOs engaged in accounting control fraud can use the four-ingredient “recipe” to maximize reported income (and real losses) and will not repeat that discussion here.

The neo-classical economics literature also ignores how banking market power could act like a “vector” that spreads market power through the real economic sector.  When banks have market power their CEOs can profit through anti-competitive control frauds.  If banks have market power their managers can maximize their incomes by exploiting that market power to simultaneously reduce their deposit costs and increase the interest rates they charge borrowers.  The combined effect is to increase the bank’s spread without taking additional credit risk in its lending.  What the neo-classical economics literature fails to recognize is that borrowers that would themselves have market power would be able to pay considerably higher interest rates on bank loans because that market power would allow them to obtain supra-normal profits.  Prospective borrowers could have market power because they were introducing a new product, were crony capitalists able to extract “rents” through their ability to get special governmental favors, or were cronies of the banks’ controlling officers.

Economic theory predicts that banks can obtain un-competitively high spreads in several circumstances.  They could have market power in the market for deposits or lending, which would allow them to pay lower interest rates for deposits and charge higher interest rates to borrowers.  They could be more efficient lenders, which could decrease both their direct costs of lending and overhead expenses.  They could be more skillful loan underwriters, which would allow them to loan with fewer losses.  These circumstances are not mutually exclusive.  A bank large enough to have market power in lending is likely to have market power in deposits.  A bank’s underwriting or lending operation could be so superior that the bank gained so much market share from its competitors that it obtained market power.

The Ecuadorian government has decided that the persistence of the very high spreads its banks extract is harmful to the nation and is adopting a tax that will reduce the largest banks’ monopoly profits (“rents”) and the compensation of their senior executives.  The proceeds will be distributed to the people of Ecuador.  The banks and their political supporters argue that the tax and limits on executive compensation will harm the banks’ depositors.  That argument is incorrect.  First, depositors do not gain when banks extract supra-normal spreads.  Depositors are bank creditors – the bank borrows money from depositors.  As is the norm for creditors, the borrower will not pay the lender any additional interest if the borrower makes a fortune investing the funds it borrowed.  If Ford Motor Co. borrows money by issuing a bond at a 6% interest rate and uses the loan proceeds to develop a new car that proves exceptionally profitable it will not pay the bondholders a higher interest rate as a “bonus” for making available the funds that produced the record profits.  The same is true with depositors – except where the bank is owned cooperatively, which is not the case with Ecuador’s large banks.

The only way depositors would be harmed would be if the tax were set so high that it caused the bank to fail.  Even then, the loss would overwhelmingly be borne by the government of Ecuador because of deposit insurance.  The Ecuadorian tax was set at a level designed to allow even banks with the lowest net interest margins to continue to be viable.  If the numbers that the banks report to the government of Ecuador are accurate the tax does not imperil any bank in Ecuador.  Governmental deposit insurance provides a compelling incentive for Ecuador not to ever tax its banks so heavily that they will fail.

The limits on the executive compensation of the banks’ senior managers should make depositors much safer.  The leading causes of catastrophic bank failures are the perverse incentives created by modern executive compensation.  Modern compensation for senior bank leaders is far too high, it is based largely on short-term reported income (which is simple for CEOs to inflate), and lacks “clawback” provisions even when the reported income proves to be fictional.  Economists, competent financial regulators, and criminologists have warned for years that compensation is criminogenic because it produces intensely perverse incentives.  The great lie about modern executive compensation is that it “aligns” the interests of shareholders and managers.  It actually further misaligns their interests.  That misalignment, however, pales compared to the conflict of interest it further aggravates between bank executives and depositors.  The interests of CEO’s of Ecuador’s largest banks are hostile to the depositors’ interests.  The CEOs’ incentive is to exploit depositors by using the banks’ market power to pay them an unduly low rate of interest.  The CEOs of Ecuador’s four largest banks demonstrated their contempt for their depositors by seeking to terrify them in a manner that could have caused a baseless run.

Similarly, in their infamous coordinated letters the CEOs of the four largest banks claimed credit for Ecuador’s economic development by claiming that their loans were what made business and employment grow in Ecuador.  Under their own logic, those CEOs have caused the four banks that dominate Ecuador to make far fewer productive loans because they were willing to loan only at supra-normal spreads.  Had they caused the banks they control to offer loans at the lower interest rates that would have been prevailed absent the four banks’ market power many more prospective businesses would have been able to get over the far lower “hurdle rate.”  These new businesses could have meant hundreds of thousands of new jobs in Ecuador if one believes the logic expressed in the bank CEOs’ letters.  The CEOs of the four largest Ecuadorian banks are among the worst drags on the Ecuadorian economy.  They have reduced lending, business formation, and employment in Ecuador.

This piece is cross-posted from New Economic Perspectives with permission.

2 Responses to “Ecuador: Bank Spreads, Taxes, Executive Compensation and Growth”

alexDecember 4th, 2012 at 4:11 pm

Sorry, I don’t get the point…
The major flaws of the article are not a ” rocket science “.
The assumption that Ecuador government will not hurt the banks because of government insurance is false. Ecuadorian government doesn’t have money to pay, so default is the only possible scenario.
Secondary, Ecuadorian banks pay 6+% on deposites. This is huge difference with, for example, US banks. Therefore, the “big” spreads are small if calculation is done as a percent of the paid interest.
Am I wrong?
Thank you.

alexDecember 4th, 2012 at 4:18 pm

Sorry, I don’t get the point…
The major flaws of the article are not a ” rocket science ”
The assumption that Ecuadorian government will not hurt the banks because of government insurance is false. Ecuadorian government doesn’t have money to pay, so default is the only possible scenario.
Secondary, Ecuadorian banks pay 6+% on deposits. This is huge difference with, for example, US banks. Therefore, the “big” spreads are small if calculation is done as a percent of the paid interest.
Am I wrong?
Thank you.

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