when she talks, bank shudder

Binyamin Applebaum  ET 11 Aug 14

Bankers are nearly unanimous on the subject of Anat R Admati, the Stanford finance professor and persistent industry gadfly: Her ideas are wildly impractical, bad for the American economy and not to be taken seriously. But after years of quixotic advocacy, Admati is reaching some very prominent ears. 

Last month, President Obama invited her and five other economists to a private lunch to discuss their ideas. She left him with a copy of The Bankers' New Clothes: What's Wrong With Banking and What to Do About It, a 2013 book she co-authored. 

A few weeks later, she testified for the first time before the Senate Banking Committee. And, in a recent speech, Stanley Fischer, vice chairman of the Federal Reserve, praised her "vigorous campaign." 

Admati's simple message is that the government is overlooking the best way to strengthen the financial system. Regulators, she says, need to worry less about what banks do with their money, and more about where the money comes from. 

Admati argues that banks are taking larger risks than other kinds of companies because they use other people's money, and the results are that they keep crashing the economy. Her solution is to make banks behave more like other companies by forcing them to reduce sharply their reliance on borrowed money. That would likely make the banking industry more stodgy and less profitable — reducing the economic risks, the executive bonuses and, for shareholders, both the risks and the profits. 

SPEED LIMITS 

"My comparison is to speed limits," Admati said in an interview near the Stanford campus. "Basically what we have here is the market has decided nobody else should be driving faster than 70 miles an hour and these are the biggest trucks with the most explosive cargo and they are driving at almost 100 miles an hour." 

In his speech, Fischer said Admati's arguments made sense in principle. "At one level, the story on capital and liquidity ratios is very simple: From the viewpoint of the stability of the financial system, more of each is better," he said. But the United States, he said, was constrained by practicality. 

If other countries aren't willing to impose stricter capital requirements on their own banks — and they don't appear to be — then unilateral increases would hurt the American banking industry and the broader economy. 

Andrew Metrick, a Yale finance professor, said that such rules could also push activity into the less regulated corners of the domestic financial system. He compared the situation to a pair of parallel highways, echoing Admati's metaphor. "If you lower the speed limit on one highway, you'll have fewer accidents on that highway," he said. "But the other road will just get more crowded."

 


'SOMETHING IS VERY WRONG' 

Before the financial crisis in 2008, Admati spent most of her time working with complicated financial models. She had never paid much attention to banking or to public policy. But as the crisis unfolded, she began reading and talking with colleagues — "like a doctor from another field of medicine visiting the emergency room," she said — and grew increasingly disconcerted by what she learned. 

Even after the crisis, banks continue to rely on debt financing far more than other kinds of corporations. Admati said she started asking one question repeatedly: Why were banks behaving so differently? Four years later, she says she's still waiting to hear a good answer. 

Admati decided to enter the public square because she felt that academics and policymakers weren't listening. The Bankers' New Clothes, which she wrote with Martin Hellwig, an economics professor at the University of Bonn, proved a turning point in her campaign. But the first step was much smaller. She was not sure how to reach a popular audience, so in 2010 she enrolled in a programme that teaches prominent women to write opinion articles. 

Her first, published in The Financial Times in the fall of 2010, was a letter co-signed by 19 other academics that criticised an international agreement on minimum bank capital standards as "far from sufficient to protect the system from recurring crises." Banking is the only industry subject to systematic capital regulation. 

Borrowing by most companies is effectively regulated by the caution of lenders. But the largest lenders to banks are depositors, who generally have no reason to be cautious because federal deposit insurance guarantees repayment of up to $250,000 even if the bank fails. This means the government, which takes the risk, must also impose the discipline. 

In the decades before the financial crisis, banks gradually convinced regulators to reduce capital requirements to very low levels. In the aftermath, banks acknowledged that some increases were necessary — they had just needed enormous bailouts, after all — but they fought to minimise those increases. 

The day after Admati's article ran, the same paper ran one by Vikram S Pandit, then the chief executive of Citigroup, arguing that the proposed standards were excessive. "The last thing the global economy needs is another economic dampener," Pandit wrote. 

ADD A DIGIT 

A 2010 analysis funded by the Clearing House Association, a trade group, concluded that an increase of 10 percentage points in capital requirements would raise interest rates by 0.25 to 0.45 percentage points. This, in the view of Admati, is a small price to pay for fewer crises. 

She notes that debt is cheaper than equity largely because of government subsidies — not just deposit insurance but also tax deductions for interest payments on other kinds of debt — so more equity would basically transfer costs from taxpayers to banks. 

Even in the short term, she says, the economic impact may well be positive. Admati says large banks should be required to raise at least 30 per cent of their funding in the form of equity, about six times more than the current average for the largest American banks. This would not affect the ability of banks to accept deposits; it would not even affect their borrowing from other sources. 

Instead, she says, banks should be required to suspend dividend payments, thus increasing their equity by retaining their profits, until they are sufficiently capitalized. She freely concedes that there is no particular science behind her 30 per cent equity figure. The point, she says, is that 5 per cent is the wrong ballpark. The proper baseline, in her view, is what the market imposes on other kinds of companies.