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As Admati and Hellwig show, using a simple mortgage to illustrate, the bankers have figured out that using somebody else’s money to pay for almost all their assets gives them a nice profit when asset prices go up and gives somebody else — often taxpayers — a painful loss when they go down.
The reason for this unfairness is the bankers’ confidence that when the crisis comes, the government will save them. They’re building their businesses on that confidence.
Bank lobbyists are undoubtedly contacting members of Congress and regulators to make sure Admati, who teaches at Stanford’s Graduate School of Business, and Hellwig, director of the Max Planck Institute for Research on Collective Goods in Bonn, Germany, don’t get a foothold with their heretical idea that banks should behave like other companies.
“The Bankers’ New Clothes” says a thick cushion of equity would go far to resolve many risks that bankers and regulators spectacularly failed to manage before the financial crisis. The equity providers, the bank’s shareholders, will supervise the management more closely because they can’t count on a government bailout to save their investment. Closer supervision should bring more transparency earlier about what the bank managers are doing. The lonely voices calling for the banks to be broken up may find that stiffer equity standards will create a caste of investors willing to sell bank assets at any sign they aren’t being well-managed.
The bank lobbyists who take the case to Congress and the regulatory agencies will plead that equity costs too much and that the requirement will push up the cost of borrowing for the businesses and consumers who drive the economy. But Admati and Hellwig see the argument as another example of bankers misleading the public by encouraging it to overlook the obvious. Their book’s title comes from the Hans Christian Andersen fairy tale in which only a small child is willing to point out the obvious: that the emperor has no clothes.
Banks pay more for equity than debt today because debt is subsidized by the implicit guarantee of a government bailout and by explicitly favorable tax treatment of interest, they say. Equity also costs more because banks are reckless and investors demand a greater return to compensate for that risk. When bankers take fewer risks, shareholders will accept lower returns. The cost of equity will go down, the thinking goes.
Admati and Hellwig also want the equity ratio calculated against total assets, not the risk-weighted ones that are themselves a form of financial perversity: “The weights are determined by a mixture of politics, tradition, genuine and make-believe science, and the banks’ self-interest.” Greek government debt was as risk-free as German government debt even after the Greeks defaulted, they write.
The difference between J.P. Morgan’s total assets and its risk-weighted ones is about a trillion dollars. The logic of risk- weighting is that some assets — Greek government bonds or triple-A rated mortgage securities, anyone? — have less risk than others. The practice of risk-weighting is that risk is identified when it’s too late.