The following is an excellent excerpt from the book “THE BANKERS’ NEW CLOTHES: What’s Wrong with Banking and What to Do About it” by Anat Admati and Martin Hellwig from Chapter One titled “The Emperors of Banking Have No Clothes” on page 7and I quote: “A Sampling of the Bankers’ New Clothes – This confusion is insidious because it biases the debate, suggesting costs and trade-offs that do not actually exist. The trade-offs exist for reserve requirements, which call for banks to hold some fraction of their deposits in cash or in deposits with the central bank. However, capital requirements are distinct from reserve requirements and do not give rise to the same trade-offs. Confusing the two makes it easier to argue that capital requirements prevent banks from lending when this is not actually true.
At least for banks that are organized as corporations, bank capital requirements have no automatic effect on bank lending. If capital requirements are increased, there is nothing in the regulation that would prevent these corporations from issuing additional shares and raising new funds to make any loans and investments that they might find profitable.
Banks that do not have access to the stock markets, as well as those that do, can increase their equity by retaining and reinvesting their profits. What the banks would choose to do with the funds and why they would make these choices are different matters that are obviously important. But there is no sense in which capital regulation forces banks to shrink or prevents them from making loans. Viable banks can increase their reliance on unborrowed funds without any reduction in lending.
In arguing against increased capital requirements, advocates for banks often say that capital, that is, equity, is expensive and that, if they must have more equity, their costs will increase. This mantra is so self-evident to banking specialists that they usually see no need to justify it. But why is it that banks hate equity so much and view it a expensive? In what exact sense is it expensive, and what does this mean for society and for policy?
We can test this argument by comparing banks to other corporations. Corporations in most industries are free to borrow as much as they want if they can find someone to make them loans. Yet there is no other sector in which corporations borrow anywhere near as much as banks do. For the vast majority of nonfinancial corporations in the United States, borrowing represents less than 50 percent of assets. Some highly successful companies do not borrow at all. By contrast, for banks, debt often accounts for more than 90 percent of assets. For some large European banks, the fraction is even higher, above 97 percent; it also was that high for some major U.S. investment banks before 2007, as well as for the mortgage giants, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), which were bailed out. The new regulations that the banking industry complains about would still allow debt to fund 97 percent of bank assets.
If capital is expensive, as bankers suggest, and borrowing is cheap, why doesn’t this also apply to other corporations? Why don’t nonbanks borrow more and economize on the supposedly expensive equity? Are these other corporations doing something wrong? For example, why doesn’t Apple, which has to borrow at all, borrow some money by issuing some debt and use the proceeds to pay its shareholders? Wouldn’t this be beneficial, replacing the company’s expensive equity with cheap debt? Or is there something fundamentally different about the funding costs of banks?
The business of banking is different, but bank stocks are held by the same investors, or by investors who value stock in the same way, as those who invest in other companies. They do not look different from other stocks; all stocks allow their owners to receive dividends and sell the shares for cash at the prevailing price in the stock market. Why would bank stocks be any different from those of other corporations?
One difference that is important for bank funding costs became evident in 2008: if an important bank gets into trouble and comes close to defaulting on its debt, there is a good chance that the government or the central bank will support it to prevent default. A few corporations outside the financial sector have also benefited from government bailouts, for example the auto industry, but those instances have been rare exceptions. In the financial sector, bailouts of large institutions, or of many institutions if they get into trouble at the same time, have become the rule.
If a company can count on being bailed out by the government when it cannot pay its debts and its creditors do not worry much about its defaulting, creditors will be happy to lend to the company. The company will therefore find that borrowing is cheap and, by comparison, other ways to fund investments, such as equity, are expensive. The interest that the company has to pay on its debt will not reflect its true default risk because that is partly borne by the taxpayer. From the perspective of the banks, therefore, borrowing is cheap. But this is true only because the costs of bank borrowing are partly borne by taxpayers.
When bank lobbyists claim that having more equity would raise their costs, they never mention the costs to taxpayers of making their borrowing cheap. At times they even deny the presence of the subsidies to their debt. Yet there is significant evidence that bank borrowing benefits from the prospect of taxpayer bailouts. For example, credit rating agencies sometimes assign higher ratings to bank debt than they would if the banks had no prospect of being bailed out. These higher ratings directly lower the interest rates at which banks can borrow. The value of this benefit is greater the more a bank borrows.
These are just a few examples of what we refer to as the bankers’ new clothes, flawed and misleading claims that are made in discussions about banking regulation. Many of the claims resonate with basic feelings, yet they have no more substance than the emperor’s fictitious clothes in [Hans Christian] Andersen’s story.
This book will provide you with a framework for thinking about the issues so you can gain a better understanding of them and see flawed arguments for what they are. It does not require any expertise in or prior knowledge of economics, finance, or banking. You might think that this is not your field. However, if the discussion of banking and banking regulation is left only to those who are directly concerned, the financial system will continue to be at risk from unsafe banking, and all of us may suffer the consequences. Only pressures from the public can bring forth the necessary political will. Without public pressure and political will, we can expect little change.
Many of the bankers’ new clothes that we expose in this book are related to how much banks borrow. In order to understand the issues, we first explore the impact of borrowing by individuals and companies on risk and on investments more generally. This will enable us to see where banks are similar to other companies and where they are different.
Borrowing is not the only topic of the book. Many more flawed claims are made in the debate on banking regulation. Most of these bankers’ new clothes are also bugbears, warnings of unintended consequences meant to scare policymakers out of doing something without focusing properly on the issues or proposing how the actual problems should be solved.
For example, leading bankers often call for so-called level playing fields in regulation. They warn that their ability to hold their own in global competition might suffer if regulation were any stricter for them than for banks in other countries. This argument is also used by other industries, and it can succeed in weakening regulation, but it is invalid. A country’s public policy should not be concerned about the success of its banks or other firms as such, because success that is achieved by taxpayer subsidies or by exposing the public to excessive risks—for example, the risks of pollution or of a financial crisis—is not beneficial to the economy and to society.
On the issue of how much banks should borrow, as well as how much risk they should take, there is a fundamental conflict between what is good for bankers privately and what is good for the broader economy. By having policies that encourage bank borrowing and risk taking, we paradoxically make it attractive for banks to choose levels of debt and risk that are harmful without serving any useful purpose.
Whatever else we do, imposing significant restrictions on banks’ borrowing is a simple and highly cost-effective way to reduce risks to the economy without imposing any significant cost on society. Curbing excessive and harmful risk taking by bankers may require additional laws and regulations.
Why Bank Safety Matters – Why should we care so much about the safety of banks and about how much banks borrow? The more anyone borrows, the greater the likelihood that the debts cannot be paid. When this happens, most borrowers go into bankruptcy, the lenders’ claims are frozen until a court has determined what they can be paid, and then, usually, the lenders are paid much less than what they are owed.
When a borrower is a bank, the damage resulting from its defaulting on its debts can be great, affecting many beyond those directly involved with the bank. This is especially true when the bank is a systemically important financial institution like JPMorgan Chase or Deutsche Bank, with massive operations all over the globe. Excessive borrowing by such banks expose all of us to risks, costs, and inefficiencies that are entirely unnecessary.
In the run-up to the financial crisis, the debts of many large banks financed 97 percent or more of their assets. Lehman Brothers in the United States, Hypo Real Estate in Germany, Dexia in Belgium, and France, and UBS in Switzerland had many hundreds of billions of dollars, euros, or Swiss francs in debt. Lehman Brothers filed for bankruptcy in September 2008. The other three avoided bankruptcy only because they were bailed out by their governments.
The Lehman Brothers bankruptcy caused severe disruption and damage to the global financial system. Stock prices imploded, investors withdrew from money market funds, money market funds refused to renew their loans to banks, and banks stopped lending to each other. Banks furiously tried to sell assets, which further depressed prices. Within two weeks, many banks faced the prospect of default.
To prevent a complete meltdown of the system, government and central banks all over the world provided financial institutions with funding and with guarantees for the institutions’ debts. These interventions stopped the decline, but the downturn in economic activity was still the sharpest since the Great Depression. Anton Valukas, the lawyer appointed by the bankruptcy court to investigate Lehman Brothers, put it succinctly; “Everybody got hurt. The entire economy has suffered from the fall of Lehman Brothers. . . the whole world.”
In the fall of 2008, many financial institutions besides Lehman Brothers were also vulnerable. Ben Bernanke, chairman of the Federal Reserve, told the Financial Crisis Inquiry Commission (FCIC) that “out of maybe. . . 13 of the most important financial institutions in the United States, 12 were at risk of failure within a period of a week or two.” Some or all of the major banks in Belgium, France, Germany, Iceland, Ireland, the Netherlands, Switzerland, and the United Kingdom failed or were at significant risk of failing had their governments not bailed them out.
Accounts of the crisis often focus on the various breakdowns of bank funding between August 2007 and October 2008. Much bank funding consisted of very short-term debt. Banks were therefore vulnerable to the risk that his debt would not be renewed. The deeper reason for the breakdowns, however, was that banks were highly indebted. When banks suffered losses, investors, including other financial institutions, lost confidence and cut off funding, fearing that the banks might become unable to repay their debts. The Lehman Brothers bankruptcy itself heightened investors’ concerns by showing that even a large financial institution might not be bailed out, and therefore that default of such an institution was a real possibility.
The problem posed by some banks being regarded as too big to fail is greater today than it was in 2008. Since then, the largest U.S. banks have become much larger. On March 31, 2012, the debt of JPMorgan Chase was valued at $2.13 trillion and that of Bank of America at $1.95 trillion, more than three times the debt of Lehman Brothers. The debts of the five largest banks in the United States totaled around $8 trillion. These figures would have been even larger under the accounting rules used in Europe.
In Europe, the largest banks are of similar size. Because European economies are smaller than that of the United States, the problem is even more serious there. Relative to the overall economy, banks are significantly larger in Europe than in the United States, especially in some of the smaller countries. In Ireland and Iceland before the crisis, the banking systems had become so large that, when the banks failed, these countries’ economies collapsed.
The traumatic Lehman experience has scared most governments into believing that large global banks must not be allowed to fail. Should any of these large banks get into serious difficulties, however, we may discover that they are not only too big to fail but also too big to save. There will be no good options.
The consequences of letting a large bank fail are probably more severe today than in the case of Lehman Brothers in 2008, but saving them might cripple their countries. The experiences of Ireland and Spain provide a taste of what can happen if large banking systems have to be saved by their governments. In both countries, the governments were unable to deal with their banking problems on their own, so they had to ask for support from the International Monetary Fund and from the European Union.
This situation makes it all the more important to prevent scenarios in which governments must choose between letting a major institution fail or committing to an expensive bailout. One approach is to try to create mechanisms that would allow large banks to fail without disrupting the economy or requiring public support. Although useful efforts have been made in this direction, this remains a challenge for global banks. Even the best resolution mechanism is likely to be disruptive and costly.
Whatever else might be done, significantly reducing the reliance of large banks on borrowing is the most straightforward and cost-effective approach to crisis prevention. Current and proposed regulations go in the right direction, but they are far from sufficient and have serious flaws. This situation reflects the success of bank lobbying and the prevalence of flawed arguments, the bankers’ new clothes, in the debate. To make progress, the issues must be clarified.
The present situation is perverse. It is as if we were to subsidize the chemical industry to intentionally pollute rivers and lakes. 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.
Most investments involve risks. If investments are funded by borrowings, the risks are borne not just by the borrowers but also by the lenders, and possibly by others. The borrowing itself magnifies risk, and it creates fundamental conflicts of interest that can also lead to inefficiencies. These conflicts of interest and inefficiencies explain much of what is wrong with banking and suggest what to do about it.
To understand the issues—and to see through the bankers’ new clothes—it is important to understand the relation between borrowing and risk. This is the subject to which we turn now. In the next two chapters we discuss the relation between borrowing and risk without a focus on banking. Then we turn to banking, risk in banking, and the implications of excessive risk for the financial system. This background will frame our discussion of banking regulation and the bankers’ new clothes in later chapters. The discussion will also throw light on the politics of banking. Providing a better understanding of the issues and the political challenge has been our motivation in writing this book.”
(SINCE THE BANKS ARE USING PR TO COVER UP THEIR MISTAKES, WHAT REALLY MATTERS IS—ARE THEY INCREASING RESERVES? IT BETTER BE HIGH ENOUGH TO MAKE UP FOR MISTAKES THAT HAPPENED IN THE 1930s AND AGAIN IN 2008 AND IF THEY DON’T RAISE IT HIGH ENOUGH TO COVER ALL THE TOXIC DERIVATIVES THEY ARE PLAYING WITH, WE COULD HAVE ANOTHER CRASH. REMEMBER PRESIDENT FRANKLIN ROOSEVELT, WHEN HE CLOSED THE BANKS FOR A WEEK, WHO WAS CONSIDERED A LIBERAL DEMOCRATIC PRESIDENT SAID THAT ‘BANKS MUST HAVE 16 AND A HALF TO 18 PERCENT RESERVE ON CHECKING TO HANDLE THE FLUCTUATING DAY-TO-DAY MARKET. AND SINCE WE DON’T HAVE ANYWHERE NEAR THAT ON THE BIG INVESTMENT BANKS, WHICH IS CLOSER TO 5 PERCENT OR LESS, IT’S LIKE THE AUTHORS SAID IN THIS SEGMENT, THE PROBLEM NOW IS BIGGER THAN IN 2008, WHICH MAKES YOU WONDER WHAT DID WE DO WITH THE TIME TO IMPLEMENT REGULATIONS? WHEN IN REALITY, THEY WERE LYING OT THE PUBLIC AND STILL BACKSLIDING, WITH INVESTMENT BANKS HAVING TWO SETS OF BOOKS AND A U.S. ATTORNEY GENERAL THAT WASN’T BACKING UP THE STATE ATTORNEYS GENERAL WHO WERE SUING THE BANKS.
LaVern Isely, Overtaxed Independent Middle Class Taxpayer and Public Citizen and AARP Members