Reforming Global Finance

The Emperors of Banking Have No Clothes

Why have bankers and their lobbyists been so successful in stymieing efforts to rein in the financial sector?

Credit: D.B. King-Flickr (CC BY 2.0)

Takeaways


  • Many of the claims made by leading bankers and banking experts have as much substance as the emperor's new clothes in the Hans Christian Andersen story.
  • Can something be done at a reasonable cost to reduce the likelihood of banks' failing and causing a costly crisis? In a word, yes.
  • Will the banking reforms that have been decided upon so far make banking less accident-prone? No.
  • The benefits of a more ambitious reform would be significant. Contrary to the claims of leading bankers, the relevant costs to society would be quite small.

A major reason for the success of bank lobbying is that banking has a certain mystique. There is a pervasive myth that banks and banking are special and different from all other companies and industries in the economy. Anyone who questions the mystique and the claims that are made is at risk of being declared incompetent to participate in the discussion.

However, many of the claims made by leading bankers and banking experts actually have as much substance as the emperor’s new clothes in the Hans Christian Andersen story.

Unfortunately, most people do not challenge these claims. The specialists’ facade of competence and confidence is too intimidating. Even people who know better fail to speak up. The emperors of banking may be naked, but they continue parading without being challenged about their attire.

Many have a sense that something is wrong with banking and have serious questions:

  Why did banks get into so much trouble in the crisis?

  Why were banks and other financial institutions bailed out? Were the bailouts necessary?

  Will these institutions be bailed out again if they run into trouble?

  Will new regulations help or hurt? Are they too tough or not tough enough?

In response to these questions, leading bankers may admit that mistakes were made, but they portray the crisis primarily as a fluke. They claim that it would be costly and wasteful to tighten regulation to forestall an event that might happen once in a hundred years.

Tighter regulation, we are warned, would interfere with what banks do to support the economy — and this would have serious “unintended consequences.”

Politicians are taken in by the lobbying. For all the outrage they expressed during the crisis, they have done little to actually address the issues. The lessons from the crisis have not been learned, and little has actually changed.

Do not believe those who tell you that things are better now than they had been prior to the financial crisis of 2007-09, and that we have a safer system that is getting even better as reforms are put in place.

Today’s banking system, even with the reforms that have been undertaken, is as dangerous and fragile as the system that brought us that crisis. This system benefits bankers, but it exposes the rest of us to unnecessary and costly risks. It also distorts the economy in significant ways.

Can something be done at a reasonable cost to reduce the likelihood of banks’ failing and causing a costly crisis? In a word, yes. Will the reforms that have been decided upon achieve this aim? No.

Can we have regulations that greatly increase the health and safety of the system while still allowing banks to do everything the economy needs them to do? Yes. Would we, as a society, have to sacrifice anything substantial to have a better banking system? No.

One clear direction for reform is to insist that banks and other financial institutions rely much less on borrowing to fund their investments. The reforms that have been agreed upon since 2008 — particularly the so-called Basel III accord regarding capital requirements — are woefully insufficient in this respect, and they maintain previous approaches that have not worked well.

This proposal still allows banks to fund up to 97% of their assets by borrowing — which is dangerous and entirely unjustified. The benefits of a more ambitious reform would be significant. And contrary to the claims of leading bankers and others, the relevant costs to society would be quite small, if they exist at all.

Requiring that banks use a lot more unborrowed funds, rather than borrowing as much, is a way to limit the share of assets that is funded by borrowing. Because unborrowed funds are obtained without any promise to make specific payments at particular times, having more equity enhances the bank’s ability to absorb losses on its assets.

No healthy corporations in other industries borrow as much as banks do, and there is nothing about banking that makes it essential or efficient that they rely on borrowing to fund 90% or more of their assets.

Why do banks choose to borrow so much? The main reason is that their creditors agree to lend to them under relatively favorable terms and often do not worry much about the risks banks take. Depositors can count on deposit insurance, and other creditors, too, particularly those of large banks considered “too big to fail,” count on the government to step in and ensure they are fully paid.

The interest rates banks pay on their debt reflect the fact that their creditors are not too concerned about default. Even small banks benefit from the fact that, if many of them run into trouble at the same time, there is a good chance that the government will step in and support them.

The present situation, in which guarantees and subsidies encourage banks to borrow and to take more risk, is perverse. It is as if we were to subsidize the chemical industry to pollute rivers and lakes even when there are clean alternatives that would, except for the subsidies, have the same cost.

Such subsidies would encourage additional pollution. If the industry were asked to limit the pollution, it would complain that its costs would increase. Would such complaints make us tolerate the pollution?

Subsidizing banks to borrow excessively and take on so much risk that the entire banking system is threatened is just like subsidizing and encouraging companies to pollute when they have clean alternatives.

This situation can change. With a proper diagnosis and focus, highly beneficial steps to protect the public from excessive risks in banking and to improve the system can be taken immediately. Why have policymakers not taken these actions? The problem is a mix of confusion, self-interest and the politics of banking.

Bankers and banking experts use confusing and impenetrable jargon, implying that banking is very complicated. The impenetrability allows them to confuse policymakers and the public, and it muddles the debate.

Politicians, regulators, and others often prefer to avoid challenging the banking industry. Their incentives may be distorted by campaign contributions, prospects of future careers in banking, or the desire to have bank funds be directed towards pet projects.

Convenient narratives allow them to disguise their own responsibility for failed policies. Academics get caught up in theories based on the belief that what we see must be efficient. In such a situation, invalid arguments can win the policy debate.

Banking is not difficult to understand. Most of the issues are quite straightforward. But banking does need to be demystified and the issues do need to be explained to widen the circle of participants in the debate.

We want to encourage more people to form and to trust their opinions, to ask questions, to express doubts and to challenge the flawed arguments that pervade the policy debate.

If more people understand the issues, politicians and regulators will be more accountable to the public. Flawed and dangerous narratives — “the bankers’ new clothes” — must not win.

Editor’s note: This article is adapted from The Bankers’ New Clothes: What’s Wrong With Banking and What To Do About It (Princeton) by Anat Admati and Martin Hellwig. Published by arrangement with the authors and Princeton University Press. Copyright © 2013 by Princeton University Press.

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About Anat Admati

Anat Admati is a professor of finance and economics at Stanford University's Graduate School of Business.

About Martin Hellwig

Martin Hellwig is director at the Max Planck Institute for Research on Collective Goods in Bonn, Germany.

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