Anat Admati is a Professor of Finance and Economics at Stanford University, but she is more widely known for her critically acclaimed book: The Bankers' New Clothes: What's Wrong With Banking and What to Do About It. Alongside her co-author, Martin Hellwig, Professor Admati deconstructs the idea that a safer financial system is inherently damaging to economic growth.
At an economics conference last month, Professor Admati and I sat down to discuss the central themes of her book (see full video below). Unsurprisingly, the conversation quickly turned to derivatives. Many have asserted that the reason for the financial crash was a banking sector overrun by the sheer volume of derivatives contracts held both on, and off, the balance sheet. However, since the value of these contracts is hinged on the loans and mortgages of ordinary Americans, the damage of a misstep can extend far beyond the bank itself.
According to Ms. Admati, derivatives were not simply the problem, but also a symptom of deeper issues within the banking culture. Speaking in Toronto last month, she said: "I don't think people appreciate that banks are the only entities that live on single-digit equity [ratios]...I mean the banks wouldn't lend to someone who had their balance sheets."
The argument here is basically the too-big-to-fail line of reasoning. Banks get a pass on low levels of equity because they're protected by a government backstop. And I'm not just talking about deposit insurance, but also the silent understanding that financial integration has made our economy incapable of shouldering the collapse of a large bank.
Invoking the memory of the JPMorgan Chase (NYSE:JPM) $9 billion trading debacle, Ms. Admati says that London Whale was a warning. The very fact it happened at all displayed a mind-boggling lack of internal risk controls, especially considering that we know a relatively small loss by one firm can be leveraged through the interconnected financial system, causing significant damage along the way. While that certainly calls for greater oversight, it's less obvious what the regulation should look like.
Of course, the Federal Reserve and the FDIC have helped big banks like JP Morgan come up with plans for a managed bankruptcy (in case insolvency reemerges as a real threat), but Ms. Admati isn't impressed. "That's not the solution, just like the solution for trucks speeding at 90 miles per hour isn't to say 'I've got ambulances ready' when you can set a speed limit at 60."
Gaurav Seetharam has no position in any stocks mentioned. The Motley Fool owns shares of JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.