The Bankers' New Clothes

1. Banks are dangerously undercapitalized, threatening economic stability

When banks borrow too much and take too much risk, they harm the public.

Excessive leverage: Banks typically have equity levels of only 2-3% of their total assets, meaning a small decline in asset values can render them insolvent. This high leverage magnifies risks and makes the financial system fragile.

Systemic risk: The interconnectedness of banks means that the failure of one institution can trigger a domino effect, threatening the entire financial system. This was evident in the 2008 financial crisis, where the collapse of Lehman Brothers led to widespread panic and economic turmoil.

Public cost: When banks fail or require bailouts, the costs are often borne by taxpayers and the broader economy. The 2008 crisis led to trillions of dollars in economic losses, high unemployment, and long-lasting social consequences.

2. The financial system's fragility is unnecessary and can be fixed

If banks have considerably more equity, the financial system will be safer, healthier, and less distorted.

Simple solution: Requiring banks to fund their assets with significantly more equity (20-30% instead of 2-3%) would dramatically reduce the risk of bank failures and financial crises.

No trade-offs: Contrary to bankers' claims, higher equity requirements do not reduce banks' ability to lend or harm economic growth. In fact, better-capitalized banks are more stable and better able to support the economy consistently.

Historical precedent: In the 19th and early 20th centuries, banks often had equity levels of 20-30% or higher. The shift to extremely high leverage is a relatively recent phenomenon, driven in part by implicit government guarantees and misaligned incentives.

3. Equity is not expensive for banks; this claim is a fallacy

The statement that equity is expensive because shareholders require higher returns than debt holders is false and quite flawed.

Misunderstanding risk: Bankers often claim that equity is expensive because shareholders demand higher returns than debtholders. This ignores the fact that as a bank uses more equity, the risk per dollar of equity decreases, lowering the required return.

Modigliani-Miller theorem: This fundamental principle of finance states that, under certain conditions, a firm's overall cost of capital is independent of its capital structure. While real-world conditions aren't perfect, the basic logic still applies to banks.

Tax distortions: The perceived "cheapness" of debt is largely due to its preferential tax treatment and implicit government guarantees, which are subsidies paid for by taxpayers, not true economic benefits.

4. Regulatory capture and politics hinder effective banking reform

Those who prefer the status quo have dominated the debate, while those who argue for effective reform have not been as successful.

Revolving door: Many regulators come from the banking industry or hope to work there in the future, creating conflicts of interest and a tendency to favor industry views.

Lobbying power: Banks spend enormous sums on lobbying and have significant political influence, allowing them to shape regulations in their favor.

Complexity and obfuscation: The banking industry often uses complex jargon and misleading arguments to confuse policymakers and the public, making effective reform more difficult.

5. Higher equity requirements benefit society at no real cost

From society's perspective, the benefits are large and the costs are hard to find; there are virtually no trade-offs.

Enhanced stability: Higher equity levels make banks more resilient to losses, reducing the likelihood of bank failures and financial crises.

Better lending: Well-capitalized banks are better able to continue lending during economic downturns, supporting economic recovery.

No opportunity cost: Equity is not "idle money" – it's invested in the bank's assets and activities, just like debt funding.

Benefits outweigh costs: Any potential increase in banks' funding costs due to higher equity requirements is vastly outweighed by the reduced risk of costly financial crises and bailouts.

6. Bank executives' focus on ROE leads to excessive risk-taking

ROE by itself is a flawed measure of performance.

Misleading metric: Return on Equity (ROE) can be artificially inflated by increasing leverage, encouraging banks to take on more debt and risk.

Misaligned incentives: Executive compensation tied to ROE encourages short-term risk-taking at the expense of long-term stability.

Ignoring risk: High ROE often reflects high risk-taking rather than true value creation. A focus on risk-adjusted returns would provide a more accurate picture of bank performance.

7. "Too big to fail" creates perverse incentives and moral hazard

The prospect of benefiting from too-big-to-fail status can give banks strong incentives to grow, merge, borrow, and take risks in ways that take the most advantage of the potential or actual guarantees.

Implicit subsidy: The expectation of government bailouts allows large banks to borrow at artificially low rates, encouraging excessive risk-taking and growth.

Competitive distortion: "Too big to fail" banks have an unfair advantage over smaller institutions, leading to increased concentration in the banking sector.

Taxpayer burden: The implicit guarantee transfers risk from banks to taxpayers, who ultimately bear the cost of bailouts.

8. Liquidity is not the main problem; insolvency is the real threat

Liquidity problems are quite often caused by solvency problems, because concerns about solvency induce creditors to pull out.

Misdiagnosis: Many policymakers focus on providing liquidity support to banks, but this doesn't address underlying solvency issues.

Hidden insolvency: Banks often delay recognizing losses, masking their true financial condition and making it difficult to address problems early.

Zombie banks: Keeping insolvent banks afloat through liquidity support can lead to "zombie banks" that continue to operate but are unable to lend effectively, harming economic recovery.

9. Complex financial instruments increase systemic risk

Derivatives allow the magnification of risks in ways quite similar to the effects of leverage discussed in Chapter 3. However, the risks cannot be seen by looking at a bank's balance sheet.

Hidden leverage: Derivatives and other complex instruments can create enormous exposures that don't appear on banks' balance sheets, making it difficult to assess true risk levels.

Interconnectedness: These instruments create complex webs of relationships between financial institutions, increasing the potential for contagion during crises.

Opacity: The complexity of many financial instruments makes it difficult for regulators, investors, and even bank managers to fully understand and manage the risks involved.

10. Effective regulation and strong political will are essential for reform

The critical ingredient—still missing—is political will.

Clear rules: Regulations should focus on simple, hard-to-manipulate measures like the ratio of equity to total assets, rather than complex risk-weighted metrics that can be gamed.

Enforcement: Regulators need the authority and willingness to enforce rules, including the ability to quickly resolve failing banks.

Public pressure: Overcoming industry resistance to reform requires sustained public demand for a safer financial system and politicians who prioritize the public interest over narrow industry concerns.

Last updated: September 1, 2024