How to Avoid Another Catastrophic Financial Crisis

It's been almost five years since the depths of the financial crisis, and we're still feeling its aftereffects today. Unemployment in the U.S. remains far too high, and economic growth is still unsatisfactory. Overall, the financial crisis of 2007-2009 could result in a decline of economic output of more than $13 trillion, according to the Government Accountability Office.

One might think that our political and financial leaders would be committed to doing everything in their power to prevent a similar crisis in the future. Unfortunately, that hasn't appeared to be the case so far. In The Bankers' New Clothes, Anat Admati and Martin Hellwig argue that today's banking system "is as dangerous and fragile as the system that brought us the recent crisis." They also believe that there hasn't been enough serious analysis of how the financial system could be made safer.

This sorry state of affairs should be unacceptable to all Americans. Fortunately, Admati and Hellwig provide a very clear proposal for real reform of our banking system. The Bankers' New Clothes should be required reading for our policymakers in Washington, D.C.

It's not rocket science
Admati and Hellwig's central argument is very simple. They believe that our banks rely too much on borrowing to fund their investments and that they should be required to have much higher equity levels than they currently maintain. Nowadays, debt often accounts for more than 90% of total assets for some of our larger banks. The authors, on the other hand, declare that they "have never received a coherent answer to the question of why banks should not have equity levels between 20 and 30 percent of their total assets."

Admati and Hellwig are very effective in showing precisely how borrowing magnifies risk and what excessive levels of debt means for banks. Clearly, our bankers are not unaware of what can go wrong by not having enough equity on their balance sheets. To illustrate the point, the authors quote Nobel laureate Merton Miller, who said, "I can't help smiling at complaints from bankers about their capital requirements, knowing that they have always imposed even stronger requirements on people in debt to them."

Too big to fail is an even bigger problem now
The key problem with excessive borrowing by the large Wall Street banks, of course, is that the costs are often borne by others. The authors point out that during the financial crisis, bank losses were picked up by taxpayers, creditors, and shareholders, while executives were able to keep their huge pay packages from previous years. Nowadays, the very legitimate fear of contagion ensures that our government would be reluctant to let one of our big banks fail, despite the tough talk on Sunday morning television shows. And this reluctance leads to even cheaper credit for the big banks, which in turn encourages even more borrowing. The authors believe that too-big-to-fail policies have "strong and perverse effects on banks' behavior."

The case of JPMorgan (NYSE: JPM  ) is particularly instructive. Admati and Hellwig show us that its "fortress balance sheet" is actually much more vulnerable than one might think. The company has almost $1 trillion in commitments to some business units that it doesn't include on its balance sheet, and its accounting treatment of derivatives also makes its balance sheet appear stronger than it actually is. If JP Morgan ever got into serious trouble, of course, it could have extremely serious consequences for the U.S. economy, according to the authors.

Throughout the book, Admati and Hellwig emphasize that insisting on more equity and less debt is the best and easiest solution of all. Alas, they believe that Basel III, the most recent global standard on capital adequacy, is insufficient to the task at hand. Even though Basel III is supposed to be stricter, it still permits banks to have equity that is just 3% of total assets in some instances.

Ultimately, the authors argue that equity relative to total assets needs to be increased considerably, and that this will not impose meaningful costs on society. And Admati and Hellwig firmly reject the notion that increased capital requirements will result in decreased lending – in fact, they feel strongly that that particular argument is a red herring put out there by the bankers themselves.

Too complex to understand?
If the solution is as simple as Admati and Hellwig suggest, then why haven't we adopted it by now? Here, the authors are very persuasive. They argue that Wall Street bankers have succeeded in making this topic appear to be too complicated for ordinary citizens to consider. Individuals who don't know the difference between reserve requirements and capital requirements, for example, are understandably reluctant to weigh in on the broader topic.

Reform along the lines proposed may actually be a possibility in the near future, however. The new banking bill put forward by Senators Sherrod Brown and David Vitter seems to be informed by some of the thinking expressed by Admati and Hellwig.

One of the greatest strengths of this book is that it clearly explains the issues for the ordinary reader. Financial reform shouldn't be left solely to Wall Street bankers and their captured policymakers in Washington, D.C., to decide. Regular citizens must make their voices heard, and this book will help them understand the basic terminology and concepts. I encourage everyone with an interest in effective financial reform to pick up a copy today. This just might be the most important book of 2013.

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  • Report this Comment On May 01, 2013, at 10:34 AM, XXF wrote:

    So on one side of this argument we have bankers, with whatever ills they're accused of currently, and on the other side we have people like these schmucks who are intent on deceiving people into supporting them. The "debt" that these banks are in that they keep referring to as so bad are, by and large, CUSTOMER DEPOSITS, which are both FDIC insured up to 250,000 and held partially by the bank in cash. The article is intentionally misleading about a book that is intentionally misleading.

    The bailout that went to actual banks (not Fannie and Freddie or auto unions, ect.) totaled about $245 billion. The amount paid by banks to the bail out fund are about $267 billion which includes a 5% preferred dividend rate (that's right, the banks had to borrow the money at 5%, which is higher than my mortgage rate). The bailout to the banks was more about keeping confidence in their liquidity to prevent runs than actually providing capital, which most banks did not want and paid back at the earliest possible moment when they were legally allowed to. (Approx. $20B has not been paid back to this point from banks that were bailed out and did need the capital).

    There were actual bailouts, the largest three being to Fannie and Freddie, AIG, and the "automotive sector" (political payoff for the unions that shafted retail investors).

    Anyway, my point is that bailouts are bad and there was a lot of money going where it shouldn't during the financial crisis, but the vast majority of banks were not at fault. Recent academic research has shown that real estate bankers were more invested personally than average people (they believed in the real estate market and what they were doing). Hate spewing and misinformation does not help us to move forward at all.

  • Report this Comment On May 01, 2013, at 12:43 PM, grahamsway wrote:

    It's not clear if more equity is the answer to any future banking crisis. While it seems a simple solution there are two main issues. The first is that theoretically if banks need to have a large fixed % amount of equity to assets it will surely reduce their ability to expand their balance sheet via lending or investment. At 30% eq/asset for a trillion $ bank a 20% rise in their assets would mean a $60 billion raise in equity. If that's the case any respectable banker is going to try to find ways around it which, probably being successful, might add more risk to the system than less.

    The second issue to the simplistic more equity argument is the practical case. Excesses in the banking system usually build up during great times and at great times nobody is going to believe that more equity is needed and the rules enforced during the scary days are quickly forgotten.

    I think if one looks back at the 2008 crisis, though more equity might have helped a bit, if the banks had not been stupid enough to be suckered into the mania and over invested in crummy RE and if AIG really had the CDS insurance they sold, things would have been tough but not nearly as catastrophic.

    The real answer to keeping banks solvent might be to get a decent group of astute bank examiners at the key financial players making sure that the banks maintain their diversification and that proper hedging support is in place.

    Unfortunately, I wouldn't hold my breath waiting for that to happen.

  • Report this Comment On May 01, 2013, at 1:27 PM, JeffMLittle wrote:

    All in all, this is part of a free market trend that was starting to snowball shortly after World War II and got a lot of momentum starting in 1980. If you look at just about any problem we have in society that shows up in graph form, you can see the inflection point of the graph is in the 1980-1985 period. The main exception to that is labor. Improvements to productivity stopped falling through to wage increases between 1965 and 1970 when we let our unions die.

    The real problem in society today is that for some reason we treat people who say "The free market can do no wrong" differently than we treat used car dealers who sell you a lemon by lying about it.

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