Out of this nettle, danger, we pluck this flower, safety – Shakespeare. It is easy to argue the merits of safety. It is much harder to argue the case against, by reference to its opportunity cost. As a general observation, modern society appears to have an unfortunate tendency to ratchet up ever higher levels of safety. This is often done with little regard for the consequences, possibly unintended and unwanted in hindsight, in a seemingly automatic and irreversible trend. In this article we shall briefly explore how this phenomenon has manifested itself in a variety of financial matters, and in particular how it might affect enterprise and risk-taking.
Once a safety net is erected it is open to abuse by those who would purposely jump on it- Martin Webster
Possibly the most ambitious safety apparatus ever devised by Man is the welfare state. Nobody could argue against its noble intent. However, once a safety net is erected it is open to abuse by those who would purposely jump on it. This can lead to a lifeless army of dependents, wallowing in their sense of entitlement but without a sense of purpose.
The welfare system accounts for a substantial portion of government expenditure in developed economies, and maintaining it is a fundamental challenge. The eurozone crisis is in large part a reflection of this struggle.
Standard theory tells us that required returns are positively correlated to perceived risk. An entity’s equity is riskier than its debt – it ranks last, its returns are volatile, and there is no redemption date (an especially important distinction if the equity is illiquid, as is the case for all local equities – albeit to different degrees).
In that context, it is incongruous that local bond holders are offered a tax incentive in the form of a 15 per cent final withholding tax – yet the income derived from equity is taxed at the marginal rate of tax (likely to be 35 per cent).
It also distorts the capital market – all things being equal an entity is more likely to offer a bond instrument in response to the (artificially stimulated) demand. Ironically, this can lead to excessive financial risk since it incentivises a sub-optimal debt/equity split on the part of the corporate. Many local companies are characterised, in my opinion, by being over-indebted and under-capitalised. That is less of an issue when the economy is growing rapidly, but it can become more of a problem in recessionary times.
The tax allowances related to the cost of capital also induce an irrational advantage in favour of debt. Interest payable (on debt) is allowable as a tax expense, resulting in a lower taxable income. Why then is a notional cost of equity not similarly allowable as a deduction against profits? Is it because it is a non cash item? But surely that is irrelevant if an accruals concept is adopted?
Indeed, not only should there be an allowance but it should be greater for equity, since the cost of equity is necessarily greater than the cost of debt. This anomaly also incentivises the accumulation of corporate debt and indirectly disincentivises a more entrepreneurial deployment of savings (in the form of equity) – which the banks are only happy to take care of.
The banks are also happy to go beyond their traditional role as assessors of loan applications (they are credit institutions after all, or at least used to be), and roll the dice in the capital markets – for their gain, but with your savings. The losses are however also yours, if they are too great to be absorbed by the bank itself and the taxpayer is forced to bail it out.
Why does this happen? To a large extent, banking regulations encourage this behaviour by assigning a risk free status to government debt. (That is a joke of course, but the joke is on us). The banks need to put up capital against their assets, commensurate (in theory) with the risk of those assets. Risk free assets require zero capital against them.
So imagine a bank is making a strategic decision as to whether to lend directly to businesses in a risky macro environment, or buy a government bond instead. Not only is the bond perceived as less risky – it is also more liquid (since it can be traded in a secondary market), and less capital intensive (so the capital ‘saved’ can be deployed for other means). In other words, it is both safer and more lucrative in certain aspects. Is it any wonder we are faced with a credit crunch?
(The article continues next week.)
This article is the objective and independent opinion of the author. The information contained in the article is based on public information. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.
www.curmiandpartners.com
Mr Webster is head of equity research at Curmi and Partners Ltd.