Bankers' New Clothes? Authors' New Clothes? Whose Clothes are Real?

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

We've just finished this popular criticism of modern banking by Anat Admati and Martin Hellwig.  We pay the highest compliment (in our view) that a book of this type can earn:  the authors are right.  Well, backtracking just a bit, the authors are qualitatively right on their central point.

Admati and Hellwig have one clear and dominant message:  banks should have much more equity.  The book pushes risk weighting of assets to the side and complains that modern banks - even after the Credit Crisis - may have equity that is just 3% of total assets.  The authors want 20-30% equity as the minimum rather than 3%.  Say it again - banks should have much more equity!

These bank antagonists spend much of the book (correctly) anticipating bankers' objections and giving sound refutations.  For example, increased capital requirements will not reduce lending IF banks choose to raise equity rather than reduce assets.  Also, bank ROE may certainly decline with increased equity, but the bank shareholders' RISK also declines - making the outcome more of a trade-off than a penalty to equity investors.

The downside of Bankers' New Clothes is everything else.  There is nothing resembling a justification of the 20-30% equity-to-asset prescription.  Admati and Hellwig simply state that bank equity was higher in the 19th century and was in this 20-30% range at the beginning of the 20th century.  This "analysis" is not adequate - the authors would have retained more credibility by admitting this shortcoming themselves.

While Admati and Hellwig give reasonably thoughtful discussions of recent failures of regulation, unholy alliances between governments and banks, the negative consequences of political meddling with banks, and the great desirability to just let banks fail, they then DEFEND and argue for the preservation of regulators, government and political control, and the imperative NOT to let banks fail!!

The Admati-Hellwig thesis is simple (and simple is good!):  force banks to have 20-30% equity relative to assets and don't change anything else.  We like the first part (qualitatively) ....