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) ....

How Soon They Forget!! (Or Did They Never Learn?)

Hard to believe - we learned today that the EU is troubled by new Fed rules for foreign banks operating in the U.S.

Michel Barnier, one of those innumerable European commissioners nobody really keeps track of, is worried.  He's fretting about the potential impact on the global level playing field since we must always ensure competition on an equal footing.

Where's the substance??!!

Why isn't M. Barnier making the strongest case he possibly can that European banks have plenty of capital now?!  Prove - or at least argue - that the banks on his side of the Atlantic are highly immune to insolvency risk and that they no longer have assets much longer in maturity than their liabilities.  In other words, make the argument that your banks are strong and NOT just that you want regulation to be "fair!"

These concepts of "fairness" and "level playing field" are not new!  Putting such amorphous and non-essential concerns ahead of true substantive analysis of banking risk is one of the many enablers of the disarray of the past 7 years.

See here the text of a conference presentation we made in Sydney in 2001.  Here's an excerpt:

"Why are the BIS rules so bad?  Well, the portfolio credit risk puzzle is quite difficult.  More importantly, BIS regulation is unavoidably a political process.  That means the end result must be simple and comprehensible to all, everybody - worldwide! - must agree, and all banks and countries must be treated “fairly” (where “fairness” is generally in the eye of the allegedly offended).  That can’t work.  We end up with rules that are wrong but for which there is universal agreement."

(If we had it to do over again, we'd certainly leave out the idea that rating agencies could do a better job than the BIS.  Live and learn!)