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 Chase & Co. (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 JPMorgan Chase & Co. (NYSE:JPM) ever got into serious trouble, of course, it could have extremely serious consequences for the U.S. economy, according to the authors.