Notes on "The bankers' new clothes: what's wrong with banking and what to do about it" (Anat Admati and Martin Hellwig)

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