The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It , by Anat Admati and Martin Hellwig

How institutions must change to prevent future financial meltdowns

Thu, Oct 17, 2013, 12:52

   
 

Book Title:
The Bankers' New Clothes: What's Wrong with Banking and What to Do about It

ISBN-13:
978-0691156842

Author:
Anat Admati and Martin Hellwig

Publisher:
Princeton University Press

Guideline Price:
Dollar29.95

Here’s a straightforward book about banks, their place in society and how they should be financed, written by two respected academic economists. Although their professional reputation has been built on some quite technical analytical work, the authors do a good job in addressing a general audience. Anyone feeling unsure about the meaning of such words as leverage, debt and equity, or about the distinction between the concepts of insolvency and illiquidity, will find secure footing here.

The main message of the book is an unpalatable one for existing shareholders of banks, but it has much to recommend it as a basis for public policy.

In a nutshell, what Admati and Hellwig are saying is that the world would be a better place if banks sourced more of their funding in the form of equity capital, and less of it from depositors. The underlying idea is that, whereas banking works well only when depositors are confident that they will get their money back, investors in equity shares know that the value of their investments will fluctuate with the fortunes of the bank. The larger the cushion of loss-absorbing capital, the less danger that losses will be so large as to threaten the depositors.

As in other countries, Irish banks operated before the crisis with only a thin layer of equity capital, about 3 to 5 per cent of total assets. Loan losses burned through all of that and more, with the result that the Government, which had stepped in with its notorious blanket guarantee, incurred a heavy burden.

Bankers worldwide often assert that for regulators to impose higher equity-capital requirements would severely curtail the availability of credit to the economy. That such arguments are not only largely fallacious but also self-serving is a key theme of the authors.

They emphasise that banks allowed to operate with too thin a layer of loss-absorbing capital can, in effect, gamble with the funds that depositors give to them for safe-keeping. The fruits of any good periods redound to the shareholders; a bad patch will result in losses that fall largely on the depositors and bondholders, or on the governments that often implicitly or explicitly guarantee many of those liabilities. Allowing banks considered “too big to fail” to operate with only a thin layer of equity capital has amounted to a large subsidy to their shareholders (and management).

Practitioners may chafe at the authors’ tendency to glide over some practical complications, particularly in relation to the challenges of transition to a regime of much higher capital requirements, but, as a guide to a future safer banking world, the blueprint advanced here seems right. The authors are also right to demystify the bugbears that vested interests invented to discourage change. Phrases such as “the present system should be given a fair trial” and “the time is not ripe” enrage the authors, who quote with approval the old aphorism that time has a trick of getting rotten before it is ripe.

In fact, Admati and Hellwig would turn the clock back a century to when equity capital typically represented 20 to 30 per cent of bank funding, more than 10 times what some international banks reported in the run-up to the present crisis.

Higher capital requirements, though not as high as that, are now very much on the agreed policy agenda worldwide. The fourth European capital-requirements directive (known as CRDIV), which Irish negotiators have helped bring to a conclusion during our presidency in recent weeks, requires European banks to reach higher capital ratios by 2019, in line with the earlier worldwide agreement known as Basel III.

The process of getting from here to there in the next few years in Ireland will illustrate some of the transitional problems elided by the authors. The Irish banks will need to attract more investment in the form of equity capital by that deadline, and it is clear that the Government, having already committed so much to enable the banks to repay their deposit and bond creditors, will have little appetite for more.

Instead, the aim must be to attract that investment from external investors, public or private. Key to that is for the Irish banks to have convinced investors that they have recovered control over the management of their delinquent loan portfolio, identified sustainable solutions for borrowers in difficulty, ensured that all borrowers that can service their loans are doing so, and dealt with the other cost penalties preventing them from returning to profitability.

In that way, potential equity investors will not be faced with such a discouraging level of uncertainty as to make them reluctant to venture the further investments that are needed. That is the key to making the banks investible again and, as such, no longer a drag on the Irish public purse.

A striking feature of The Bankers’ New Clothes is that the authors have included more than 100 pages of very interesting endnotes. These serve as an excellent guide to a well-selected portion of the recent voluminous literature on financial regulation – much of it, of course, accessible online. Here are some of the most interesting digressions and amplifications of their argument, including some juicy facts and sharp judgments on other scholars and authorities.

Readers will find it illuminating, for example, to read that the US financial industry spent $477 million on lobbying in 2011 alone. The former US regulator Sheila Bair’s recent memoir is evidence of just how such lobbying has affected the implementation of laws and regulations both in the US and internationally.

By labelling them as “credit default swaps” US financiers ensured that a huge volume of high-risk insurance contracts would remain off the regulatory radar for a decade, before they played a central role in the near meltdown of the US financial system in September 2008.

More regulation is not always better regulation, and the authors point out just how complex financial regulation has become worldwide, with the additional complexity in some areas potentially adding to risk rather than reducing it. The advantage of relying on capital as a key tool of regulation is that it is a multipurpose buffer, insulating customer and government both, from risks that can be foreseen and those that cannot.

Had the high-capital buffers advocated in this book been in effect for Ireland in the first decade of this century, they might have been sufficient for Anglo Irish Bank and Irish Nationwide Building Society to absorb the extraordinary level of property-related loan losses that have unfolded. And the banking system as a whole would not have been threatened. Besides, the shareholders of such highly capitalised banks would have tried to ensure that they were managed in a much more cautious way. Lacking the bank credit that fuelled it, the property boom would have been muted.

So, although neither the Irish banks nor those elsewhere are anywhere near having the levels of capital sought by Admati and Hellwig, they are moving in the recommended direction as they work step by step to restore profitability (involving the difficult process of dealing realistically with distressed borrowings) and to converge towards the levels of capital now mandated for the future.

Patrick Honohan is governor of the Central Bank of Ireland