Naked truths about banking

Anat Admati and Martin Hellwig contradict established myths that bankers spread about global banking

"There are known unknowns; that is to say there are things that we now know that we don't know. But there are also unknown unknowns; there are things we do not know we don't know."
- Donald Rumsfeld,
former US Defence Secretary

Whenever bankers objected to raising the capital of their institutions under the Basel norms on the ground that it was costly, I used to wonder why this should be the case. Does equity not form part of working capital deployed in their businesses? If so, how is equity, as such, costly vis-a-vis borrowing through deposits and other means? The book under review comprehensively deals with such myths in the world of banking, which the authors call "the bankers' new clothes". It consists of three parts: "Borrowing, Banking and Risk", "The Case for More Bank Equity" and "Moving Forward". There are 13 chapters, with 108 pages of copious notes at the end that are as informative as the main text.

The authors explode a number of myths spread by bankers. For reasons of space, only some of the more important myths and the responses are listed. (1) Banks are so different from all other businesses that the basic principles of economics and finance do not apply to them - on the other hand, the principles are the same. (2) Tighter restrictions on banks' borrowing might increase bank safety, but it would come at the expense of growth. This is not necessarily so. (3) Banks must "set aside" capital to satisfy new regulations - a variation of the "capital-is-costly theme" mentioned at the beginning. This is due to confusing capital with the cash reserve that does not earn a return. (4) The ability of banks to hold their own against global competition might suffer if regulation were stricter for them than for banks in other countries ("the level playing" argument). This ignores risk-taking. (5) Large banks are too big to fail, disrupting the economy - hence the need to be rescued by the government. The cost of saving banks may be even greater. (6) The financial crisis of 2007-09 was primarily caused by the problem of liquidity and not insolvency, since financial institutions did not have access to markets. It arose because the latter diagnosed it correctly as insolvency. (7) Media reports give the impression that the risk in lending comes mainly from speculation gone wrong. When banks suffer huge losses from systematic mistakes in lending decisions or the maturity mismatch between their assets and liabilities, it does not make news. (8) Derivatives and new techniques for risk management have benefited society by providing better means of sharing risks. They have, however, also expanded the scope for gambling and can be used in unrecognisable ways that increase, rather than decrease, risks in the system. Donald Rumsfeld's remark cited at the beginning makes the point clear. The authors point out that trading in financial claims is more important for many banks than loans in their balance sheets.

The theme of the book is that banks have assumed excessive risks on the grounds of the myths listed above with considerable cost to the economic system and taxpayers. The authors caution the reader that today's banking system, even with the proposed reforms, is as dangerous and fragile as the one that brought us to the recent crisis. They recommend a number of reforms. The emphasis is on increasing the equity requirements of banks. They are dissatisfied with Basel III norms.

One major criticism of an otherwise eminently readable book is that there is no reference to the interface between bank regulation and monetary policy, though there are sporadic references to the US Fed's role in the financial crisis. When I looked at the index, I was surprised that there was only one entry - and that too related to a note at the end of the book. Yet one of the cardinal lessons of the recent crisis is the close link between monetary policy, banking practices and financial stability that has led to special monitoring arrangements in many countries. At the time the US was discussing the framework of its financial architecture, Thomas Jefferson, third US president, famously said bankers were more dangerous than standing armies in the field because of the financial clout they commanded. His observation is still relevant. The easy money policy followed by the Fed in the earlier years was much praised at that time for the prosperity it brought to the US economy. It is now considered the villain of the piece because of the adverse selection of loan proposals and subprime mortgages that it spawned, sowing the seeds of the crisis. One past study of the European Central Bank showed how the capital-asset ratio had a restraining influence on the growth of money supply in the euro system.

The authors have written the book for the enlightenment of the average reader who has no background in economics, finance or quantitative fields. But it can be read by anyone interested in banking - bankers, policy makers and researchers.

THE BANKERS' NEW CLOTHES
What's Wrong with Banking and What to do About it
Anat Admati and Martin Hellwig
Princeton University Press
398 pages; $29.95