'Bankers' New Clothes' Leave Too Little Skin In The Game
At a hearing in Washington on March 6, Attorney General Eric Holder admitted to senators why it has been hard to go after big bank executives:
"It does become difficult for us to prosecute them when we are hit with indications that if you do prosecute, if you do bring a criminal charge, it will have a negative impact on the national economy, perhaps even the world economy. And I think that is a function of the fact that some of these institutions have become too large."
The comment might be startling in Washington: Regulators recently gave a thumbs-up to nearly all of the big banks, after testing their ability to withstand another crisis. But Holder's less-than optimistic remarks come as no surprise to Stanford finance professor Anat Admati. She's co-author of a new book called The Banker's New Clothes, and she shares Holder's concern about overly large banks.
But Admati emphasizes another problem: how much debt banks have. Banks can borrow cheaply, thanks to government guarantees, so they load up on debt. Admati says that heavy reliance on borrowed funds makes the banking system dangerously fragile. She joins NPR's Renee Montagne to explain why banks borrow more than they should, how new regulations aren't tough enough and how less government support would lead to a stronger economy.
On Eric Holder's claim that it's challenging to prosecute banks
"He was saying that the banks are too large, but the issue is really: Why would there be this negative effect on the world economy if he prosecutes them? And that's because they would somehow fail, or get distressed. And why does that happen? That happens when you borrow too much. So it's not about 'too big to fail,' but it's about the likelihood of failing, which is the likelihood of being, somehow having difficulty paying your debt, just like homeowners might when they have very little down payment or equity in their house. And for other companies, we don't regulate how much they borrow, and yet they don't borrow very much — not as much as banks — even though we allow them to. And so the banks just like to borrow, but as they do that they put all of us at excessive risk and danger."
On the problems of excessive borrowing and the use of complex financial instruments
"It manifests itself in these instruments because they allow the banks to use all kinds of tricks to borrow more and to hide all the risk in borrowing that happens. And so they can manipulate the regulation and they can actually be riskier than they appear, and all of this is just living on the edge and not being prepared enough, with your own money, indeed, to various eventualities, to what might happen."
On new regulations and banks' resistance to carrying more equity
"So the requirements now, which the regulators will tell you are so tough, actually still allow the banks to use borrowed money for 97 percent of their investment and have just 3 percent equity, so even if it's a little bit, just a little bit more of a buffer, it's still not a healthy place to be. ...
"If they find that they cannot live with much more equity, then we have to wonder about their business model and the viability of having such a banking system that possibly is quite bloated and is distorting the rest of the economy. If the only way they can live is on subsidized borrowing, then we have to be concerned about why that is."
On what would make the banking system more stable
"Well, I would definitely want to move to a system in which the banks have a lot more skin in the game, are funding themselves with a much healthier mix of debt and equity, and to transition to that system shouldn't take very long. The banks that cannot raise new equity are showing us a great weakness, and some banks might be too weak to exist, and the time to take care of that is now and not in a crisis. ...
"I would like them to build up and maintain their ability to withstand losses through a much, much healthier range so that we deliver to the public a stable and healthy system that can make loans and that can do everything that we need it to do, and without being so distorted and dangerous.
"I think the banks should be made to be less dependent on supports. ... The government needs to make sure that they are safer on their own, because their support allows them to have better terms for borrowing, and that's unfair to the rest of the economy."
RENEE MONTAGNE, HOST:
At a hearing last week, Attorney General Eric Holder admitted to senators why it's been hard to go after big bank executives.
(SOUNDBITE OF SPEECH)
ATTORNEY GENERAL ERIC HOLDER: It does become difficult for us to prosecute them when we are hit with indications that if you do prosecute, if you do bring a criminal charge, it will have a negative impact on the national economy, perhaps even the world economy. And I think that is a function of the fact that some of these institutions have become too large.
MONTAGNE: That startling comment may be news in Washington, where regulators gave a thumbs-up last week to nearly all the big banks, based on a stress-test of their ability to withstand a crisis. The attorney general's explanation is no surprise, though, to Stanford financial economist Anat Admati. She is coauthor of a new book called "The Bankers' New Clothes."
ANAT ADMATI: People are saying that the banks are too large, but the issue is really: Why would there be this negative effect on the world economy if he prosecutes them? And that's because they would somehow fail or get distressed. And why does that happen? That happens when you borrow too much. So it's not about too big to fail, but it's about the likelihood of failing, which is the likelihood of being somehow having difficulty paying your debt, just like homeowners might when they have very little down-payment or equity in their house.
MONTAGNE: One thing, speaking of regular folks, I mean, it had not really occurred to me, but you point out that of the debt that banks carry - and they carry about 97, 98 percent debt - say my savings account is basically a loan to the bank, a loan that I can take back at any time.
ADMATI: Exactly. Our deposits are kind of the starting point of their debt. They borrow from money market funds. They borrow from each other. They have other bondholders. They promise money in thousands of ways. They have ways to borrow in which they basically sell you something overnight, and then they promise to buy it back the next day. It's called repos.
MONTAGNE: So, back again, what you're saying and what the book is saying is that people think that maybe the complicated, obscure financial instruments that have come to be thought of as having brought the banks down, were really not the biggest problem. The biggest problem is something that continues on and goes on, and that's that banks simply do not have enough skin in the game.
ADMATI: Yes. And all of this is just living on the edge and not being prepared enough with your own money, indeed, to what might happen.
MONTAGNE: Well, what about all the new regulations that have gone into effect? Wouldn't any of them, or some combination of them, catch this problem?
ADMATI: So, the requirements now - which the regulators will tell you are so tough - actually still allow the banks to use borrowed money for 97 percent of their investment, and have just 3 percent equity. So even if it's a little more than that, just as a little bit more of a buffer, it's still not a healthy place to be.
MONTAGNE: But banks have said that if they have to have more money that hasn't been borrowed, that that would be a problem for them. They wouldn't be able to lend.
ADMATI: Well, but the statement's just false, that they can't lend. If they cannot raise money in the form of equity and they cannot with, say, 20 or 30 percent equity, then you have to wonder about the viability of their business model. So the equity does not prevent them from lending, but they might find it more beneficial to borrow, because it's subsidized. So if they live on subsidies, really, and they're telling us that they don't have a viable business with equity that's standard elsewhere, then probably there's too much banking, and they're has to be some shrinkage, which would be probably good for the economy.
MONTAGNE: What would you like to see to make the banking system more stable?
ADMATI: One obvious thing to do is to not pay dividends. This repeats mistakes that were made right before the crisis and all through the crisis, which is allowing banks to pay an amount of money. Just from 2007, until early 2009, and through the worst of the crisis, that was equivalent to half of the amount of the money in TARP that the government had to invest in the banks.
MONTAGNE: Beyond that, what broader things might the banks do to make them more stable?
ADMATI: I would like them to build up and maintain their ability to withstand losses to a much, much healthier range, so that we deliver to the public a stable and healthy system that can make loans and can do everything that we need it to do without being so distorted and dangerous.
MONTAGNE: Thank you very much for joining us.
ADMATI: Thank you for having me.
MONTAGNE: Anat Admati is professor of finance and economics at Stanford's Graduate School of Business. She's coauthor with Martin Hellwig of "The Bankers' New Clothes: What's Wrong with Banking and What to Do about It." There's an excerpt at npr.org. Transcript provided by NPR, Copyright NPR.