Financial engineering can be damaging to public and private sectors

The last financial crisis taught us some of the risks to the economy when "financial engineering" gets out of hand. Property developers had borrowed nearly all of their capital from the banks and builders also relied on the banks for most of their working capital. In each case, the owners or shareholders had little of their own money at risk as most of it came from the banks.

In turn, banks had reduced their spare capital, maximising their lending.

This was a house of cards, because the risky ventures relied on each other to stay upright.

When the builders and property developers made big losses they did not have spare capital: instead they defaulted on their loans to the banks, finding themselves insolvent. In the face of this avalanche of defaults, the banks too were insolvent. It was left to the taxpayer to bail out the banks.

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The rush to depend on loans rather than equity was driven by two different factors. A desire by investors to maximise returns on their stakes, while undervaluing risk, and an asymmetry in the corporate tax system that affects most developed economies.

If the owners of a business reduce their stake by borrowing to replace their own equity, they may not significantly affect the total surplus earned by the business. However, if the rate of interest is sufficiently low, they end up earning the same profit with a much lower stake. This can make it much more profitable for the investor.

Because the investor’s liability is limited to their stake in the company, what they stand to lose is capped: they increase the odds on their bet, accepting higher risk, while limiting the size of their bet.

This is referred to as leveraging the company and, because of the increased risk, the borrowing is referred to as junk bonds, generally commanding a high interest rate.

The problem with the run-up to the crisis in the mid-2000s was that banks massively underpriced the risk they were taking on. This greatly enhanced their profits in the short term, as they increased their lending, but the consequences were catastrophic for the shareholders in the banks, and ultimately for the taxpayer.

Tax efficient

A second factor driving debt finance is that the corporate tax system favours it. Taxable profits are calculated on the basis of the residual surplus after paying interest. Thus, if a company pays interest to a subsidiary outside Ireland, that interest payment will not be taxed in Ireland. It is only the after-interest profit that will be taxed.

This principle is generally applied across developed economies. It encourages firms to borrow more and rely less on equity, increasing risk of default in the face of an unexpected downturn.

It would make sense to reform the corporate tax system and treat the return on equity and debt symmetrically. However, such a change might be difficult to implement unilaterally.

For most companies, where they are not essential to the economy, their owners are free to structure their capital as they will. If they go bust that is a problem for the lenders the shareholders and the employees. Provided that the business is not systemically important, like banks, that is generally not a problem for the economy.

However, for banks, regulation has been reformed, requiring them to act in a much more prudent way. As a result, coming into the Covid crisis they had a much bigger insulating layer of capital to protect them.

Utilities

Where unregulated financial engineering can also have serious negative economic effects is in the case of utilities, such as water, electricity, airports and telecommunications. They are often natural monopolies, providing vital services to the economy. However, if they rely too heavily on borrowing they will increase risk. In turn, if the shareholder capital is insufficient, they may not be able to borrow to invest in the network.

This has been a problem with the telecommunications network. When Telecom Éireann (Eir) was privatised, the new owners borrowed heavily, reducing shareholder capital so that, ultimately, they couldn't finance new investment.

The regulator should have had the power to prevent this in the late 1990s. If the company had been regulated in this way, we might never have needed a national broadband plan.

The capital structure of State-owned utilities, such as the ESB, is also important if they are to expand their vital services. They need to be profitable to maintain the State's equity and allow them to borrow to invest for our future.

Inappropriate financial engineering can be damaging to both the public and the private sector.