March 17, 2013 9:02 pm

Why bankers are intellectually naked

A definitive explanation of the industry’s economics warns the causes of the financial crisis have not gone away and will return

The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About It, by Anat Admati and Martin Hellwig, Princeton, RRP£19.95, RRP$29.95

 

The UK’s Independent Commission on Banking, of which I was a member, made a modest proposal: the proportion of the balance sheet of UK retail banks that has to be funded by equity, instead of debt, should be raised to 4 per cent. This would be just a percentage point above the figure suggested by the Basel Committee on Banking Supervision. The government rejected this, because of lobbying by the banks.

Why might even so tiny an increase in the equity-funded proportion of the balance sheet be objectionable? The answer is that what is small to everybody else is huge to bankers. To them, a one-third increase in equity means a 25 per cent decline in return on equity. To bankers, the ICB’s tiny step was a big reduction in prospective returns and so in their own rewards.

If you think that running banks with so little loss-absorbing equity is crazy, you are right. This book shows you why you are right. It is the most important to emerge from the crisis.

It makes no sense to build either bridges or banks sure to collapse in the first big storm. One makes banks stronger by forcing them to fund themselves with more equity and less debt. In recommending this change, the authors – Anat Admati of Stanford and Martin Hellwig of the Max Planck Institute – are bold. They want an equity ratio of 20-30 per cent. This is not mad. The case is grounded in the financial theory bankers apply to everything, except themselves.

Attentive readers will learn that financial fragility is a feature of the system, not a bug. Banking is more dangerous than they dare imagine. The public have, willy nilly, become risk-bearers of last resort. Protected by this generosity, bankers gain vastly on the upside while shifting the downside on to others. At worst, they can devour a state’s fiscal capacity.

The authors achieve three things. First, they explain basic financial theory with simple examples that any moderately numerate individual can understand. Second, they show that these basic ideas apply, with modest differences, also to banking. Finally, they prove that, in opposing them, bankers and their apologists have spun intellectual raiment as invisible as the emperor’s new clothes.

Readers will learn, for example, that “the notion that the required return on equity is fixed and independent of a bank’s funding mix is as fallacious for banks as it is for nonfinancial corporations”. If equity is indeed expensive, it is because there is far too little of it or because the balance sheets are too risky. Alternatively, equity may just seem costly because of “debt overhangs” – situations in which much of the benefit of extra equity goes to creditors, because initial equity was too small. State support to creditors may also make additional equity seem expensive to banks. But this time it is only because the benefits go to taxpayers. Again, equity may seem expensive to managers. But this is probably because lower returns mean lower pay. Yet it is not in the interest of the wider public to permit debt overhangs, subsidise creditors or keep bankers’ rewards high. The bigger the costs of failures, the bigger the needed loss-absorbing equity must be.

A related item of imaginary clothing is the argument that banks simply cannot raise equity and will have to shrink their balance sheets, instead. The riposte is simple: if the bank is profitable, it must simply be told to retain earnings until higher ratios are reached; if it is unprofitable, it needs to be wound up smartly, in any case. Pollution is regulated. Economic pollution should also be regulated. Banks that are financially fragile and unprofitable are important sources of just such economic pollution.

The authors demolish other bad ideas. A popular fallacy is that banks “hold” capital. But capital is not an asset, like reserves, which replaces lending; it is a liability, like debt, which funds lending. Funding banks with equity, which easily absorbs losses, is far safer than funding them with debt, which cannot. A sophisticated mistake is the idea that capital can be properly “risk-weighted”. This has proved fatally flawed.

Allowing such important businesses to operate with almost no equity cushions encourages dangerous conduct. Banks are not special, except for what they are allowed to get away with. The problem is bigger than that banks are “too big” or “too interconnected” to fail. It is that they are so complex and so grossly undercapitalised. The model is intellectually bankrupt. The reason that this is not more widely accepted is that bankers are so influential and the economics are so widely misunderstood. Read this book. You will then understand the economics. Once you have done so, you will also appreciate that we have failed to remove the causes of the crisis. Further such crises will come.

The writer is the FT’s chief economics commentator

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