Anat Admati and Martin Hellwig, whose seminal book “The Banker’s New Clothes” outlines with clarity why the banks prefer using debt to using equity, make the case for using equity ratios as the criterion for solidity, not the Basel asset percentages. This easily grasped scenario dramatically suggests the implications for the ordinary banking customer and for our country.

If you buy a $100,000 home and put down $3000, if your home’s value increases by $4,000 you will have made a 133% return on your investment. If you funded the home with more equity, say a down payment of $20,000, your return would be only 20%.  If your home decreases in value, it would take only a $4000 decrease to put you underwater.

This is the gift to banks given by the Dodd Frank legislation. Depositors are induced to place their money in the bank, where it is safe. Depositors can also go out to third parties with a presumed guarantee of backed up money. The banks do what they want with that money. In the past decades that has involved incredibly risky propositions like securitized mortgages and plays on interest rates.   Federally guaranteed deposits up to $250,000 protect the depositor and the bank. Taxpayers pay for the banks follies, however. In TARP, the taxpayers were left holding the bag. Depositors in Cyprus paid a particularly high price.

The Admati-Hellwig proposal for demanding higher bank equity ratios to make these institutions more secure has been met with fear and scorn by the big banks. The banking lobby courted legislators creating the Dodd Frank bill assiduously to insure that only the Basel ratios would be implemented.

Banks have always argued that they would be forced to lend less if equity ratios were higher.  But this is only marginally so, and seems a small price to pay for the soundness of our banking institutions.

Interestingly, Admati had lunch with President Obama this week. While the President is no master of economics, as he begins to craft his legacy, he may be looking for bold and yet sensible moves that will help the economy.  If explained from the bully pulpit of the Presidency, equity ratios could  bathe the President in a gold aura. Let’s hope so.

Note:  Hillary Clinton, frontrunner for the Democratic Presidential ticket in 2016 is very much a captive of the banks.