Attraverso Review: The Bankers' New Clothes: What's Wrong with Banking and What to Do about It by Anat Admati and Martin Hellwig

By Professor Jeffery Atik

I have the odd habit, with academic writing, of first reading the notes and then returning to the central text. I like to see the foundation of a work. Would that I had read the notes to The Bankers' New Clothes first!

For The Bankers' New Clothes is really two books which I had read in sequence (slave as I was to the Kindle's primitive formatting). The first book -- the primary text of 228 pages -- seemed simple-minded, sometimes shrill and often tedious. It argues for a significant increase in the amount of 'capital' (a specialized term in banking regulation) banks should maintain. The second book - the 107 pages of dense notes -- reveals a much more subtle, more flexible and more open understanding of the issues. This 'book' is more useful and persuasive. I recently heard co-author Anat Admati speak in Los Angeles. She described her surprise when first viewing the book as published, that it was so 'short' when the notes were stripped away and shuttled to the back of the book. It matters (Kindle take note) how books are presented; I would have had a better impression on my first read had these rich notes been on the page or gathered at the end of each chapter. And perhaps these authors will speak up the next time they write for the broader public.

Admati and Hellwig are on a mission. They fervently believe that banks should be required to hold more capital than present rules require. And by more, they mean much much more. From current rules that require, depending of the measure, 3 to 7 percent of a bank's assets, to something on the order of 20 to 30 percent. They demonstrate that such higher levels of capital (think of this like the ratio of equity to the fair market value of a house) would significantly increase the robustness of the entire banking system, relieving the state from facing new rounds of bailouts. Moreover, as the leverage of bank's decrease, banks will be less likely to attract the risk-seeking buccaneers that have managed our great financial institutions into the ground.

Most of the argument here is negative -- Admati and Hellwig counter the various claims promoted by bankers to justify the maintenance of low pre-Crisis levels of mandatory capital. Leverage is good, of course, for bankers -- they quickly harvest a good deal of the upside (through compensation) and, together with depositors and bondholders, largely escape the downside due to government supports, including ex post bailouts. In such a topsy-turvy world, management would be dim to resist gambling wildly on high risk, high yield plays.

Bankers are the villains of this book. Their stories seduce regulators and their campaign dollars gain the uncritical support of members of Congress from both parties. There is very little resistance to their arguments and few who voice the interests of the broader public. Admati and Hellwig are to be applauded for stepping into the fight.

Consider this argument: requiring banks to hold more capital will reduce the supply of credit to the real economy -- and so will further drag out the Great Recession. Admati and Hellwig give two responses: first, this is not so, and second, even if it is, it would not be a bad thing (at least in the longer run). The supply of credit by banks -- such as the making of loans -- constitutes assets. By fixing capital requirements, the regulator necessarily limits the supply of credit for a given amount of capital. Here the bankers and Admati and Hellwig agree. If you increase the capital ratio, you must reduce the supply of credit, again for a given amount of capital. But Admati and Hellwig do not accept that the amount of capital underlying the banking system would be fixed; rather they argue that one could maintain the existing supply of credit by simply shifting the capital mix. More equity, less debt. And perhaps this would result.

Admati and Hellwig respond to the concerns of stifling the economy by proposing a phase-in of higher capital requirements -- with the newly-required additional capital to be built up from retained earnings. This would involve restrictions on the payment of dividends -- and perhaps limits on compensation as well. It does have the appeal of a moderated approach.

And they leave us with the thought that perhaps our economy does not require as much credit as we have grown used to. Perhaps, they suggest, we have been weakened by cheap credit much as we are sickened by the abundance of cheap food.

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