I’ve thoroughly enjoyed reading [amazon_link id=”0691156840″ target=”_blank” ]The Bankers’ New Clothes: What’s Wrong with Banking and What to do About It[/amazon_link] by Anat Admati and Martin Hellwig. The title refers to the fairy tale about the naked emperor whom his citizens believe to be clothed in splendid robes until one child, immune from the groupthink, points out his nudity. This book’s aim, decisively achieved, is to de-mistify the public conversation about banking so we can all understand how threadbare the industry is.

The first part of the book gives a careful explanation of leverage and the role of bank equity. While the examples seem simplistic to start with, it is a useful stepping stone to evaluating the current regulatory debate about banks’ equity ratios. The logic is straightforward: the higher banks’ equity, the less destabilising is the effect of leverage, and the less the scope for contagion between banks in a crisis. The authors explain why in 2008 contagion spread so quickly around the financial system, with the arrival of money market funds and increased globalisation also playing a role. They also argue that bankers became complacent because they believed their own quantitative risk models, foolishly.

Importantly, the book also convincingly debunks the banks’ argument that there is no need for them to increase the amount of equity they hold. As Admati and Hellwig note, we suffer from a lack of clarity of thought about this subject. They describe statements made by the industry – with examples – as “nonsensical and false”. Bankers misuse the word ‘capital’ or ‘equity’ to confuse us, the book says. Bank lobbyists say equity is expensive, and increasing the amount they need to hold will therefore reduce the amount they can lend, or raise the cost of lending. They obfuscate the fact that higher equity requirements are equivalent to a limit on the proportion of a bank’s funding that can come from borrowing or leverage. Excess leverage was precisely the reason for the gravity of the financial crisis.

“The confusion about the term bank capital is pervasive… This confusion is insidious because it biases the debate, suggesting costs and trade-offs that do not actually exist….Viable banks can increase their reliance on unborrowed funds without any reduction in lending.”

It is only non-viable banks that would be constrained in their activity.

Their return on equity in fact depends on the risks the banks are taking – as we have seen, low equity ratios pre-crisis did not result in high returns on equity. The return on equity isn’t fixed, and doesn’t have a simple inverse relationship with the amount of equity held. The ROE will depend on the debt-equity mix, among other things.

Suppose, anyway, that the cost of making loans, and therefore interest rates paid by borrowers, were to increase if banks had to hold more equity. That would be a good thing if the rates paid reflected the risks incurred more accurately. It is pretty clear that risk was under-priced before the crisis, and people borrowed too much compared to the likelihood they could repay the loan. A number of very senior bankers acknowledged as much in a conference I attended at the end of last week.

What’s more, why should banks be different from other businesses? Apple has no debt, but its 100% equity ratio does not appear to have harmed its returns. When one would consider, say, 30% equity low for another kind of business, why on earth do we accept that 3% is the ballpark for banks? Should banks not hold higher levels of equity than the rest of the business sector, to reflect the socialisation of the risks they take, and the subsidies they receive via deposit guarantees?

The middle section of the book walks through the arguments for significantly higher bank equity ratios. The final section then turns to the politics of bank regulation. As the authors note, there is a chasm between talk and action, in every country. One reason bank lobbying succeeds is that politicians believe they need to back their own nation’s banks – or at least not disadvantage them – in global competition. Thus, although French politicians talk tough about banking and financial markets, they have been least supportive of moves to tighten bank regulation including equity ratios. Yet when banks succeed in the race for global market share, it is because they are being subsidised by their taxpayers and imposing large risks on them. This is the tyranny of the idea of a ‘level playing field’.

Some regulators understand this. The Bank of England’s Andrew Haldane has argued for higher equity ratios, among other requirements – albeit in the context of a discussion of 4% rather than 3% of the total balance sheet, so still pitifully low in the eyes of The Bankers’ New Clothes. He also persuasively argues that banks should focus on return on their assets (ie. how good a job do they do of lending money for productive activities that pay a good return?) rather than the current industry obsession with return on equity. David Miles of the Monetary Policy Committee has been stronger still. In a recent column on the case for higher equity he said:

“What are the people that run banks really saying if they argue that it is very costly – even unfeasible – to use more equity funding? One interpretation is that this argument is an admission that they cannot run a private enterprise in a way which makes people willing to provide finance whose returns share in the downside and the upside. In other words, they are not able to convince people who will face the full consequences of their commercial decisions to provide funding. It is as if banks cannot play by the same rules as other enterprises in a capitalist economy – after all, capitalists are supposed to use capital. You might expect that if this is the assessment of many people who currently run banks, then they would not wish to proclaim it so loudly.”

So at least some regulators recognise the issue. The problem is translating the conclusion into the arena of political negotiations in international fora, and the obsession with not disadvantaging ‘our’ banks. Politicians have not grasped that such support for ‘our’ banks comes at the cost of the welfare of ‘our’ citizens. I’d make The Bankers’ New Clothes required reading so that policy makers and regulators really appreciate why it is so perverse that the riskiest enterprises in modern capitalist economies are the ones with the least capital. The debate needs to be reset, away from the terms in which bankers talk about regulation, mystifying the rest of us.

As the authors conclude:

“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.”

[amazon_image id=”0691156840″ link=”true” target=”_blank” size=”medium” ]The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It[/amazon_image]