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

Anat Admati & Martin Hellwig, “The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It” Princeton Univ. Press , 2013, 228 pps  plus addl 105 pages of notes

"The Emperor's New Clothes" is a short tale by Hans Christian Andersen about two weavers who promise an Emperor a new suit of clothes that is purported to be invisible to those unfit for their positions, stupid, or incompetent.  Today’s bankers have apparently employed these same weavers as lobbyists and tasked them with convincing those that govern that banks need very little equity to operate, and only those too stupid or incompetent for their positions would disagree. Furthermore, many in the crowd watching the parade have been convinced that a safer banking system would require sacrificing lending and economic growth.  This book examines those claims and the authors' credentials protect them from being labeled as stupid or incompetent. They show that banks are as fragile as they are not because they must be, but because they want to be; the compensation system of banks using ROE depends on volatility and low equity levels.

However, the banker’s (weavers) still prevail--even after the 2006 crisis, the only change is bigger banks with no more equity than before.  Too many of us feel unqualified to dispute their claims.  Yet, if anyone wanted to buy a house with 2 percent down we would not feel unqualified to dispute the wisdom of lending to them as they could be ‘underwater’ should the market devalue by only 2 percent.  The authors maintain that we need to require banks to have equity at least on the order of 20-30 percent of their total assets so that they are able to cope on their own and require no more than occasional liquidity support.  The same considerations that apply to trucks, airplanes, or nuclear reactors should apply to banks.  Public safety must be the focus.  Increasing equity requirements from 3 percent to 20-30 percent of banks’ total assets would involve only a reshuffling of financial claims in the economy to create a better and safer financial system.  Promoting the competitive success of banks in global markets is not in the public interest if this success is due to banks’ taking excessive risks at the expense of the taxpayers.  Many countries have paid dearly for the successes of their banks.

Anat Admati is the George G. C. Parker Professor of Finance and Economics at Stanford's Graduate School of Business. She serves on the FDIC Systemic Resolution Advisory Committee and has contributed to the Financial Times, Bloomberg News, and the New York Times. Martin Hellwig is a director at the Max Planck Institute for Research on Collective Goods. He was the first chair of the Advisory Scientific Committee of the European Systemic Risk Board and the co-winner of the 2012 Max Planck Research Award for his work on financial regulation.

My Notes:

Pg. 2:  Purpose of writing this book is to demystify banking and explain the issues to widen the circle of participants in the debate.  It is to enable people to challenge the flawed arguments that pervade the policy debate.  If we are to have a healthier financial system, more people must understand the issues and influence policy.

Pg. 6:  Capital regulation requires that a sufficient fraction of a bank’s investments (assets) be funded with unborrowed money.  This is similar to the requirement that a home buyer makes a minimum down payment when buying a house.  Because unborrowed funds are obtained without any promise to make specific payments at particular times, having more equity enhances the bank’s ability to absorb losses on its assets.

Pg. 21:  In some states of the U.S. mortgages have a so-called nonrecourse clause that gives a homeowner the option to abandon a house without making any further payments.  In such a case, the bank would receive the abandoned house instead of being paid in full.  Mortgages are nonrecourse in Florida, Arizona, and Texas.  In California, only the first ‘purchase money’ mortgage is nonrecourse.  California Senate Bill 458, introduced in July 2011, would extend nonrecourse protection beyond first mortgages.

Pg. 30:  Until the middle of the nineteenth century, equity levels in banks were around 40-50 percent of banks’ total investments. Also, banks operated as partnerships with unlimited liability.  Unsurprisingly, banks were careful not to take too much risk.  Unlimited liability was not abandoned in the U.S. for banks until the 1930s (when the FDIC replaced the need for customer confidence in banks).  By the 1990s U.S. banks’ equity levels had declined to 6-8 percent of their assets; similar trends were observed in other countries.

Pg. 39:  Liquidity problems are endemic to banking.  Much of the debt of banks is short-term due within months or even days or even overnight.  Many of banks’ assets, however, are loans and other investments that extend over longer periods.  Most of these assets are not traded in markets where they can be converted into cash at short notice without significant losses.

It, therefore, matters greatly whether banks are able to renew their borrowing from their creditors or to find new investors from whom to borrow when previous debts become due.  If banks cannot obtain new funding to replace earlier borrowing, they may have to sell assets at a loss.  Selling assets at greatly reduced prices may cause banks to become unable to repay their debts at all, in the future as well as in the present.

To help banks overcome liquidity problems, central banks such as the Federal Reserve allow banks to borrow while posting assets with the central bank as collateral.  This safety net has been introduced on the assumption that if the assets are sound and the banks actually have only a liquidity problem, the central bank has little to lose.  Meanwhile the banks and the financial system may be spared inefficient asset sales and a possible crisis.

Pg. 53:  The banking business model prior to the 1970s consisted of taking in deposits at 3 percent interest, making loans at 6 percent interest, and getting to the golf course by 3pm.  This came to an end in the wake of the Vietnam War and the oil price shocks of 1974 and 1979, annual inflation rates rose above 10 percent.  In parallel with inflation, interest rates in the money market also rose to double-digit levels.  Meanwhile, regulations from the 1930s restricted the interest commercial and savings banks could pay on deposits.  Under these conditions, depositors left commercial banks and savings institutions in favor of newly introduced money market mutual funds, paying much higher rates.  (This left S&L's sitting on 30-year mortgages at 6% while borrowing funds cost in excess of 10%). 

Pg. 57:  In this much riskier world of volatile interest rates, savings banks and Loan Associations in the 1980s and 1990s developed tools to transfer risks from savings banks to other investors.  A major role was played by what is called securitization, a procedure that allows commercial banks and savings banks to sell their loans and mortgages to other investors.  The word securitization refers to the fact that a group of loans that are not directly tradable in a market can be bundled together and turned into bonds, that is, securities that are tradable.

Pg. 64:  In 2007-2009 bank panic sales and asset price declines were particularly strong because many banks had very little equity, on the order of 2 percent of their total assets.  If equity accounts for only 2 percent of a bank’s total assets, a drop of 1 percent in the value of these assets wipes out half of its equity.  To clarify: suppose that the bank’s assets were initially worth $100 and its equity was worth $2.  With a loss of $1, the assets are worth $99 and the equity is worth $1.  Now suppose that no new equity is raised and the bank wants to move the ratio of its equity to its assets back to 2 percent of its total assets.  It needs to reduce its assets to $50, almost half of their $99 current value, and pay back $49 worth of debt in order for the $1 it has in equity to represent 2 percent of its assets.  This shows how intense so-called deleveraging through asset sales becomes when there is so little equity to begin with.

If instead, the bank’s initial equity was 20 percent rather than 2 percent of its total assets, a 1 percent drop in the value of its assets would wipe out only 5 percent of its equity.  If banks initially have more equity, the deleveraging effect is much less intense and is less likely to be destabilizing.

Far more value was lost in the 2000 tech bust, for instance, than in the subprime mortgages that sparked the 2008 crisis, but the tech bust did not cause a financial crisis. Why? Tech companies were funded by stocks, not short-term debt. Worried shareholders can drive down the price of a stock, but they have no right to demand that the company redeem shares at yesterday's price, so they can't drive the company to bankruptcy in a run. Depositors and other short-term creditors have a fixed-value, first-come-first-serve promise from a bank—they can run.

Pg. 65:  Before 2007 banking crises tended to be limited in scope, and most of them did not cross national boundaries. Contagion did not play much of a role.  For example, the U.S. savings and loan crisis was not felt in Europe.  The 1992 crisis in Finland and Sweden had few effects outside those countries.  The Japanese crisis, which was the greatest crisis of the 1990s and may have matched the subprime crisis of the U.S for the sheer magnitude of initial losses, had no serious impact on the U.S. and Europe.  Some crises, such as the Asian banking crises of 1996-1998 did cross national boundaries because the local banks had borrowed from banks in other countries. 

By contrast, the downturn of U.S. real estate and mortgage markets that began in 2006 triggered a truly global financial crisis.  Three effects seem to have been responsible for the vast reach of the 2007-2009 financial crises.  First, the mortgage-related securities that lost much of their value were held by financial institutions all over the world.  These financial institutions were linked to each other by the market prices of the mortgage-related assets.  When one institution’s asset sales depressed prices, other institutions were also affected because their holding of these assets became less valuable. 

Second, because the institutions that held the mortgage-related securities had very little equity to begin with, solvency concerns arose quickly, and domino effects of defaults arising from the borrowing and lending of institutions from and to one another extended over several states.  Because of the institutions' low equity positions, losses from subprime securities quickly threatened the solvency of institutions that held the securities.

Third, much of the borrowing by banks was in the form of short-term debt from financial institutions, particularly from money market funds, not officially covered by deposit insurance.  The crises of the investment banks Bear Stearns and Lehman Brothers were precipitated by the refusal of short-term lenders such as money market funds to roll over and renew their loans when they were worried about the banks’ solvency.  After the Lehman bankruptcy, investors moved out of money market funds, and the funds, in turn, were forced to withdraw from funding banks.

Pg. 85:  U.S. GAAP accounting rules (unlike European accounting rules) allow JPMorgan Chase to not count around $1.8 trillion of derivatives on its Balance sheet because the bank can use netting agreement to eliminate them from both its assets and its liabilities as if they did not matter to the bank’s financial position.  

Pg. 86:  Whereas banks emphasize their role in making loans, the balance sheet of JPMorgan Chase shows that lending is only a small fraction of the bank’s activities.  Loans represent only about $700 billion of the bank’s assets, less than a third of the GAAP representation of its assets and less than a fifth if European IFRS standards are used.  Making business loans has been less attractive to them than trading financial claims, particularly claims that promise high returns and whose risks can be hidden.

Pg. 89:  The largest bank institutions by now are not just too big to fail in the sense that failure could cause disaster but, as the experience of Iceland and Ireland shows, they may also be too big to save in the sense that rescuing them would overburden taxpayers.  There is little to suggest that banks that grow beyond about $100 billion in assets create gains in efficiency; in fact, at the largest sizes, institutions might become more inefficient and subject to serious governance and control problems.  (Of course, being perceived as too-big-to-fail gives them cheaper borrowing rates because taxpayers are perceived as backing them up).

Pg. 90:  It is now apparent that financial institutions that are systemically important, whether or not they are deposit-taking institutions, need to be subject to regulation.  Bear Stearns, Lehman’s, and LTCM were deemed sufficiently important to be kept out of bankruptcy and none were deposit-taking institutions.

Pg. 103:  Borrowing at a low rate to invest in something that promises a higher rate of return is called a “carry trade.”  If there was no risk involved in the investment, borrowing at 2 percent and receiving 5 percent for sure would actually be called an “arbitrage opportunity.”  An arbitrage opportunity is a kind of money machine.  Such money machines usually do not exist in competitive markets.

Pg. 116:  ROE by itself is a flawed measure of performance.  Actual ROE reflects economic developments such as the level of housing prices, as well as luck—for instance, how speculative trading in derivatives turned out.  ROE may be high just because a bank is taking inordinate risks—risks that do not help the shareholders because there are many ways for shareholders to take risks on their own and receive appropriate returns other than investing in banks. For instance, they can borrow to create their own leverage and their own risk.  When banks do the borrowing, they add risk to the financial system and may harm the economy.

Pg. 137:  Altogether, the bailout operations of 2008 put about $2.2 trillion of U.S. taxpayer money at risk, $900 billion through the Treasury and $1.3 trillion through the Federal Reserve.

Pg. 140:  Some countries (for example, Australia, Germany between 1997 and 2000, and, since 2004, and Belgium) have tried to neutralize the tax penalty for equity funding.  Many commissions in the U.S. have also recommended changes to the tax code to eliminate or reduce the tax incentives for corporations to borrow.

Pg. 176:  Basel III has three major flaws.  In addition to the unnecessarily long transition period, its equity requirements are far too low and, lastly, the required equity is related not to a bank’s total assets but to what is called ‘risk-weighted assets,’ which are just a fraction of total assets.  Basel II requires that banks have equity equal to at least 7 percent of their risk-weighted assets by January 1, 2019.

addenda:

"Capital" is not "reserves," and requiring more capital does not reduce funds available for lending. Capital is a source of money, not a use of money. Requiring more capital does not require banks to raise one cent more money in order to make a loan. For every extra dollar of stock the bank must issue, it need borrow one dollar less.

Nothing inherent in banking requires banks to borrow money rather than issue equity. Banks could also raise capital by retaining earnings and forgoing dividends, just as Microsoft MSFT +0.43%  did for years. Every dividend drains capital from banks and removes a layer of protection between us taxpayers and the next bailout. Ms. Admati and Mr. Hellwig are at their best in decrying U.S. regulators' decision to let banks pay dividends in 2007-08—amounting to half the TARP bailouts—and to let big banks begin paying out dividends again in 2011.

Why do banks and protective regulators howl so loudly at these simple suggestions? As Ms. Admati and Mr. Hellwig detail in their chapter "Sweet Subsidies," it's because bank debt is highly subsidized, and leverage increases the value of the subsidies to management and shareholders. To borrow without the government guarantees and expected bailouts, a bank with 3% capital would have to offer very high-interest rates—rates that would make equity look cheap. Equity is expensive for banks only because it dilutes the subsidies they get from the government. That's exactly why increasing bank equity would be cheap for taxpayers and the economy, to say nothing of removing the costs of occasional crises.