The bankers' new clothes: what's wrong with banking and what to do about it
Authors: Anat Admati and Martin Hellwig
Princeton, New Jersey :
Princeton University Press 2014
- A major reason for the
success of bank lobbying is that banking has a certain mystique
- Leading bankers portray the
crisis primarily as a fluke, an accident that is highly unlikely to recur
in our lifetimes
- Much of the research on
banking, the financial crisis, and regulatory reform is based on
assumptions under which fragility is indeed unavoidable, without assessing
the relevance of the assumptions in the real world
- One clear direction for
reform is to insist that banks and other financial institutions rely much
less on borrowing to fund their investments
- There is no other sector in
which corporations borrow anywhere near as much as banks do
- To prevent a complete
meltdown of the system, governments and central banks all over the world
provided financial institutions with funding and with guarantees for the
institutions' debts
- Borrowing creates leverage
and makes the equity investment of a borrower riskier
- The higher the borrower's
reliance on debt, the greater the likelihood that the equity will be
wiped out
- Extended liability was
ineffective in preventing bank runs and losses to depositors during the
Great Depression because of many personal bankruptcies
- Lliquidity
problem:(sometimes) a temporary
inability
- Liquidity problems are
endemic to banking
- To help banks overcome
liquidity problems, central banks such as the Fed allow banks to borrow
while posting assets with the central bank as collateral. This safety net
has been introduced on the assumption that, if the assets are sound and
the banks actually have only a liquidity problem, the central bank has
little to lose. Meanwhile, the banks and the financial system may be
spared inefficient asset sales and a possible crisis
- Insolvency is suspected when
the value of a borrower's assets is assessed to be not much higher, or
even lower, than its liabilities.
- Borrowing can be addictive
- There were relatively few
bank failures and no banking crises between 1940 and 1970, but this had
more to do with the strong performance of the economy and the remarkable
stability of exchange rates and interest rates than with the high quality
of banking in these decades. When economic performance sputtered and
exchange rates and interest rates became volatile in the 1970s,
traditional banking went into a prolonged crisis
- Many banks have developed
special capacities for making loans
- Contagion through asset price
declines can also be very strong if thee are few buyers willing to invest
in the risky assets
- Three effects seem to have
been responsible for the vast reach of the 2007-2009 financial crisis:
- The mortgage-related
securities that lost much of their value were held by financial
institutions all over the world
- Because the institutions
that held the mortgage-related securities had very little equity to begin
with, solvency concerns arose quickly, and domino effects of defaults
arising from the borrowing and lending of institutions from and to one
another extended over several stages
- Much of the borrowing by
banks was in the form of short-term debt from other financial
institutions, particularly from money market funds
- The interconnectedness and
fragility of financial institutions have also increased because new types
of financial institutions have come into the system
- Borrowing from money market
funds increases the risk of liquidity problems and runs
- Another source of increased
interconnectedness has been introduced by new techniques for managing risk
- Derivatives and new
techniques for risk management have benefited society by providing better
means of sharing risks:
- Better risk sharing can
reduce dangerous exposures to risks and can transfer risks to those who
are best able to bear them. This effect can make individual defaults and
bankruptcies less likely and improve financial and economic stability
- However, the new markets and
new techniques have also expanded the scope for gambling, and they can be
used in ways that increase rather than reduce risks in the system
- Risks from derivatives are
even larger if payments change more than proportionately with changes in
the underlying variables on which the contract depends
- The secrecy and the
complexity of the contracts and strategies used in derivatives trading
allow individual traders and individual banks to build up very large
risks, sometimes very quickly, without any effective oversight or
control
- Because derivatives can
magnify risks, extensive derivatives trading can threaten not just an
individual institution but, through contagion, the entire financial
system
- Limiting banks' exposures to
individual counterparties is useful. It reduces the risk - which is
particularly prevalent among a small number of very large megabanks - that
the failure of one institution will bring down a series of other
successive institutions, a threat that played a role in the Fed bailout of
AIG
- One approach to reform is to
find a way to break up the banks into smaller, more manageable, and less
complex entities
- Combining many types of
businesses under one roof does not necessarily increase efficiency
- Have two weaknesses:
- Protection of depositors
and the payment system is not the only concern that might induce
governments to bail out banks
- commercial banking activities can also
be a source of risks that cause banks to fail unless they are bailed out
- The key objective of banking
regulation should be to reduce the fragility of individual banks and of
the system so that it can support the economy reliably
- Government safety nets should
be expanded to cover the entire system of short-term debts of financial
institutions, nonbanks as well as banks
- Capital regulation focuses on
how banks fund their assets rather than on the assets themselves
- The view that it is more
expensive to use equity funding than to fund by borrowing is sometimes
justified by the observation that for each dollar they invest in a bank's
shares, shareholders "require" a higher return than debt holders
require
- Shareholders require higher
returns because equity bears more risks than debt
- The principle that interest
rates charged on loans reflect the likelihood that the borrower might
default and how much the lender would recover in that case can be seen in
the market for the bonds of European countries
- Return on equity (ROE) is
higher with more equity
- The more equity, the lower
the required ROE
- Explicit and implicit
government guarantees have perverse effects on the extent of borrowing and
risk raking of banks
- Excessive borrowing by banks
can expose the public to great risks
- Explicit and implicit
government guarantees have perverse effects on the extent of borrowing and
risk taking of banks
- Borrowing magnifies risks for
the borrower both on the upside and on the downside
- The prospect of benefitting
from too-big-to-fail status can giver banks strong incentives to grow,
merge, borrow, and take risks in ways that take the most advantage of the
potential or actual guarantees
- Over time issuing banknotes
has become a privilege of central banks, but deposits still provide an
important part of the funding of private banks, and they are still closely
tied to the payment system
- The role of banks in the
payment system, in the past when they issued banknotes, as well as later
with demand deposits in checking accounts, has made them vulnerable of the
risk of runs
- When banks rely mostly on
borrowed funds and then make risky investments, they become vulnerable to
insolvency risk as well as the risk of illiquidity problems and runs
- The reality is that anything
that is just as safe and as convenient as cash cannot pay a higher return
than does cash - that is, zero
- If differences in risks,
liquidity, and the interest promised are taken into account, the need for
the most perfect form of liquid asset, namely cash, is in fact fairly
small
- The increase in
interconnectedness was not due just to a desire for greater efficiency. At
least some elements of the chain of transactions were due to participants'
trying to get around the prevailing regulations
- As bankers and investors
pursued higher returns, actual or imagined, they downplayed the risks.
Banks claimed to hedge risks in ways that fooled supervisors as well as
the bankers themselves but ended up being ineffective. No one bothered to
keep track of where in the system the risks were going. Some of the gains
in returns seemed extremely small relative to the risks involved
- If banks have much more
equity, the financial system will be safer, healthier, and less distorted
- The easiest way to increase
the health and stability of the financial system is to ban banks from
making cash payouts to shareholders and to require banks to retain their
earnings until they have significantly more equity. These measures would
bring immediate benefits and have no harmful side effects on the economy;
they would strengthen banks most quickly and directly and would entail no
"unintended consequences"
- In addition to the
unnecessarily long transition period, Basel III has two other major flaws:
- Its equity requirements are
far too low
- For the most part the
required equity is related not to a bank's total assets but to what is
called "risk-weighted assets", which are just a fraction of
total assets
- Basel III requires that
banks have equity equal to at least 7 percent of their risk-weighted
assets by January 1, 2019
- Among the advantages to the
stability of the financial system of banks' operating with much more
equity is the fact that losses to banks' assets deplete equity much less
intensely and thus do not require as much of an adjustment as when banks
have less equity
- Some would say that banks
cannot raise so much equity. Such concerns are misplaced:
- Any bank that is profitable
should be able to increase its equity by retaining its earnings
- When it comes to raising
equity from investors, there is no distinction between bank stocks and
other stocks
- If banks have no profits
that they can retain or if they cannot raise new equity, they may already
be insolvent or they may not have viable business models
- The leverage ratio approach,
which specifies equity requirements relative to total assets, is
considered a backstop to eliminate the most extreme abuses of the
risk-weighting approach
- In the process of determining
how best to measure risk, the purpose of regulation was lost
- Much is wrong with banking,
and much can be done about it. If politicians and regulators fail to
protect the public, they must face pressure to change course. The next
chapter pulls together the key themes from our discussion in this book and
exposes more of the convenient and flawed narratives that help justify the
lack of action. The challenge is to make those who handle other people's
money - including bankers, politicians, and regulators - bear more of the
consequences of their decisions
- In the liquidity narrative,
the main problem for policy is to prevent runs and liquidity problems from
occurring and provide liquidity when they occur
- Bankers fight higher equity
requirements, but the only way that having more equity might actually be
costly to them is by preventing them from benefiting at the expense of
taxpayers and creditors
- The will of governments and
regulators to take the essential steps:
- Among our recommendations is
to determine which banks are insolvent and to unwind them even if the
immediate cost seem daunting
- We strongly recommend
strengthening banks by banning payouts to shareholders, such as dividends
or share repurchases, until the banks have reached much higher equity
levels than they currently maintain
- We can have a financial
system that works much better for the economy than the current system -
without sacrificing anything. But achieving this requires that politicians
and regulators focus on the public interest and carry out the necessary
steps. The critical ingredient - still missing - is political will
