Review: The Bankers’ New Clothes

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It might seem odd to think to think that an economics book might top best seller lists on any occasion, what with the appeal of Dan Brown and bright lights fiction.

For years the important books have been sidelined amongst the general populous, and for this economists mostly have themselves to blame.

This has all changed.

Thomas Piketty famously topped Amazon best-seller lists in the US earlier this year, Joseph Stiglitz sold thousands of copies of The Price of Inequality in 2012, and Paul Krugman has somehow managed to reach millions with his data heavy NYT blog.

Now there is a new book which should make it up there: Anat Admati and Martin Hellwig’s powerful analysis of how to repair a broken financial system.

Working with research refined over the last three decades, the pair cut through myths propagated to resist the wide-ranging overhaul of regulatory frameworks across the world that are needed to reduce the possibility of future financial crises.

Describing an industry clouded by layers of opacity, The Bankers’ New Clothes achieves the Herculean by writing in an accessible yet cuttingly precise manner on the intricacies of Financial Innovation and the labyrinthine challenge of trying to curb it.

As they illustrate perspicuously (geddit?) getting too close to a working regulatory framework is a difficult task when the financial beast sits at its centre.

At its core the book questions frankly whether governments have created the kind of robust system that will prevent future panics.

Why was it that the supposed end of “boom and bust” finished with the most devastating financial crisis since the Great Depression?

Admati and Hellwig argue that the debate on regulation is twisted by the adverse incentives of many writing on the issue.

They posture a simple solution: tell the banks that they cannot borrow as much to fund their investments.

This, they claim, is a simple and cost-effective way to reduce the incredible endemic risks that exist in the ‘shadow banking’ industry, where Bear Stearns were lending at 100$ for every 1$ the held in reserve.

Closer to a 10% capital requirement would give ten times the buffer, and might well have offset the Financial Crisis and saved governments billions in bailouts, with bank shareholders rather than taxpayers taking the hit for failures.

But this has been difficult to impose, or dumbed down by governments when it has been. The banking lobby claim that

Increased equity requirements would induce banks to lend less, and this would be harmful for the economy

Admati and Hellwig display articulately why this view is deeply flawed.

Banks claim that equity (money invested by shareholders) is expensive to gather, far more so than borrowing from the markets or through high street deposits.

That sounds about right, why else would the banks oppose the move?

The authors note that a closer look reveals a different story.

Equity is not expensive to acquire, at least not in comparison to borrowing. What is expensive are the taxes they have to pay on equity.

Governments tend to apply small taxes to deposits which would affect the man-on-the-street, instead hitting equity hard.

So the problem is not one of expensive equity, but of an implicit government subsidy, and the debate not one about capital requirements but about tax policy.

This is a book for anyone interested in understanding the causes and prevention of financial crises.

The Basel agreements have started to make progress on a large scale programme of raising capital requirements, but the documents are riddled with holes.

They ignore off balance-sheet funding, and look set to fall to the same fate as the US capital requirements did pre-2007. It’s a start but much is to be done.

This book is a powerful message to policymakers across the world: regulation has not gone far enough, and the deficiencies which lead to the Great Recession are still hanging over the global financial system.

George Osbourne would do well to read Admati and Hellwig, his half-attempt to support tougher regulation seems to have kicked the process backwards – a watered-down endorsement that seems far worse than an out right rejection, and the silence on the debate seems to indicate so.

In Malcolm Tucker’s insightful words ”[y]ou’re like the anti-King Midas,” “…” (well, you can guess the rest.)

Killian Troy