The Bankers’ New Clothes

by Anat Admati and Martin Hellwig

Princeton University Press

The authors’ credentials are impeccable and even intimidating.  But their message is clear and accessible.  Discussing the Basel III ratio, which outlines a bank’s capital requirements, they write: “If this number (the 3% ratio) looks outrageously low, it is because the number is outrageously low.”

Bankers have cloaked themselves in the emperor’s clothes.  These clothes are made up of deflecting words.  The first phrase you will hear from a banker is “This is too complicated for you to understand.  Only bankers can understand finance.”  Since many people, including the current President of the United States, do not understand finance, they buy into this suit of meaningless, but not innocent, words bankers now put on.

Our representatives, with notable exceptions such as Sherrod Brown, Jeff Merkley, and Elizabeth Warren, are captives of the bankers.  The bankers finance our representatives‘  campaigns, and in turn the representatives service the bankers’ needs, not those of the citizens.  We are headed for disaster after disaster unless we make it our business to understand exactly what is going on.

Anat Admati, professor of finance at Stanford University and Martin Hellwig, at the Max Planck Institute for Research, have written a compelling book, which an average citizen can grasp, mull on, and then hopefully act on at the ballot box.

The Bankers’ New Clothes shows step by step how the banks have gotten away with dragging the economy down.   Yet this is not a shrill book.  Rather it is a terrifying one, because so few of our representatives and regulators are prepared to look banks square in the eye and take action to protect the public from banks.  While ‘eyes wide shut’ is part of human frailty, its willful blindness has serious consequences.

To understand how far banks have moved from their original purpose, we must return to fundamentals.  A bank is an institution that matches up savers and borrowers to help ensure that economies function smoothly. You’ve got $1,000 you don’t need for, say, a year and want to earn income from the money until then. Or you want to buy a house and need to borrow $100,000 and pay it back over 30 years. It would be difficult, if not impossible, for someone acting alone to find either a potential borrower who needs exactly $1,000 for a year or a lender who can spare $100,000 for 30.

International banker Andreas Frank, who started life at Goldman Sachs when that bank became a casino, remarks:  ”Modern societies need banks to function.  A bank is an intermediate organization.  A bank should behave like one.  If a bank wants to make a 25% return on equity, it should become a hedge fund and have its own neck on the block.  Now the government, at taxpayer expense, makes sure the guillotine does not chop.  Crazy risks are risk free at the citizens’ expense.”

Although banks do many things, their primary role is to take in funds—called deposits—from those with money, pool them, and lend them to those who need funds.  Twenty per cent of JP Morgan Chase’s income comes from transactions like these.  Banks can make money through fees, lending, credit cards, investment banking and money management.  They prefer the Las Vegas casino model where they now make 25% on 80% of their money at taxpayers’ risk.

The solution is made clear and in fact simple by the authors: Banks should fund their investments by selling much more stock and borrowing a lot less, especially in the form of short-term debt.  Apple does this. Microsoft does this.  Bank of America does not.

Banks always threaten to stop lending if they must use more equity but the opposite is true: it is when banks have little equity that credit becomes scarce because of the overhanging debt. As Admati and Hellwig explain, profitable banks can build their equity, like most companies often do, first and foremost by retaining their earnings. They can also issue stock to investors. A bank that cannot raise equity at any price may well be too sick to survive.

Selling assets not essential to banking is not a problem and smaller banks might be more efficient if they did.

Governments all over the world provide explicit and implicit guarantees to deposits and even to other bank debt.  This means that a bank will not go down, and depositors and creditors don’t worry too much about the risks banks take.  And who pays?  The taxpayer. Regulations are an invitation to take risks that are too high for someone who is gambling with other people’s money.

A sad and also meaningless ritual has been repeated over and over again in the US:  from the Continental Illinois rescue of 1984 to the recent financial crisis.  After each crisis, the government writes new rules, drafted first by bankers, who divert attention from the real causes, the liabilities: too much debt and short-term debt.   Liabilities cause financial crises. Regulators must address them.

Yet even this focus can be a red herring.  The fundamentals of banking must be restored and then built upon. Europe is now in a mess largely because it allowed its enormous banking sector to become so sick.  Banks lending to their own governments is disastrous, but Greek bonds are still listed as ‘risk free.‘   Politicians cannot quite admit they’ve bailed out Greece and many other countries in the European Union.

This book should be mandatory reading for all concerned citizens. That includes lawmakers and regulators who are supposed to protect the public.  The Bankers’ New Clothes gives us the tools to demand more effective regulation of the banks and makes the case for treating a bank like any other company. The book clothes bankers in language we can all understand.  How radical is that?
The book’s website Bankersnewclothes.com
Available at barnesandnoble.com and amazon.com