Russ Roberts

Admati on Financial Regulation

EconTalk Episode with Anat Admati
Hosted by Russ Roberts
Hennessey on the Debt Ceiling ... Satz on Markets...


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0:36Intro. [Recording date: July 20, 2011.] Financial reform, and in particular some proposals you have made: making the banking system more stable and focusing on capital requirements. Talk about the idea of equity and the balance sheet of a firm, and what a healthy proposal would require compared to what is going on today. I think the first thing to really talk about when you talk about capital requirement is what does it mean. They use this word very differently in banking than anywhere else. So, people get very confused about this. You start having journalists explain to you. First of all, everybody says: You hold capital. That's already a big peeve I have about the word "hold," because what we are talking about, is the following. It's critical to think about balance sheets when you think about this. Everybody has a balance sheet. The government; all banks. A balance sheet basically has two sides, or it's stacked together, one on top of another. Basically, one part of it that balances with the other is what you own, what you have--what are your assets? And then against that are basically the liability and equity. These are things you can owe, versus the things that you own. These are kind of claims against the assets. These are promises you made to pay out of the assets, that will call upon the assets to pay, or the remainder, which is equity. So, equity is basically assets minus liabilities. That's what we are talking about. So, for every bank, what all this stuff that they own, which is all the loans that they made, everything that pays them; and then, on the liability side has all the stuff that they owe--the demand deposits that people can come and ask for, the money market, all this stuff, and all the bonds they issued--short terms, repos, thousands of kinds of commitments they made to pay. We call that the debt. And then the difference between them, which is usually a very small sliver in the case of banks, is the equity. They call this capital, and they talk about how much capital banks are supposed to hold, but actually that capital, it's not the banks that hold it. That equity is held by some investors. So, the holding, when they say banks hold capital or satisfied capital, or hold in reserve capital, or all of that--that's completely fleeting. So, it conjures up an image of stuff sitting around doing nothing, which is not the case. Let's go back to the balance sheet and go very slowly. I'm going to start a bank. Which is going to be problematic because I have no reputation. But let's suppose I have a reputation and I start a bank. So, I take in through my doors cash that people want to deposit. What side of the balance sheet? That's part of your debt. It's called demand deposits or demandable debt. Because they can come back any time--that's part of what banks do. They issue these kinds of debt instruments. Only banks do this usually. So, normally, when I think of capital as an economist--handicapped as I am by the fact that the only accounting I know is from a friend who I helped pass her accounting class. That's usually far from finance to know accounting. So, one source of funds for me as a bank are my deposits, which create a liability because I have to pay them back. The other way I can attract resources I can do stuff with is investors, people who buy the stock of my bank. They own a residual just like all the all the equity of the rest of the economy. So, they have a claim on the cash flow of the profits, after expenses and other things are paid. Now, if, for example, half of my assets are demand deposits, and let's say that's $500,000; and $500,000 I raise in equity among my trusted, greedy, return-hungry friends, I would have a 50-50 debt-equity mix. That's right. So, let's go to the way capital is used in regulatory discussions. In the current environment, which is ruled by Basel II and a half or whatever we're at--Basel II, III. I think the United States never adopted Basel II; overwhelmed by the financial crisis. So we never got to II. Now we are talking about III. Same principle. Basel II has capital requirements. What does that mean? Let me say it a different way. If I'm a bank and I have to keep "10%" as a capital requirement, what does that mean. The way they do it is they want to adjust it for the risk of the asset. So, they have this system that they created: the sort of measure how much equity you have, not relative to your total assets in value but relative to what they call risk-weighted assets. Is this Tier 1 and Tier 2? No, when you talk about Tier 1 as a ratio, what's the denominator? The denominator usually in all the requirements so far--in Basel III they are going to introduce some leverage ratio--but the number they are talking about, the 4.5-7 or the 7%, extra Systematically Important Financial Institutions (SIFI) charge and all that, that is equity measured in some way. There are also issues about how you measure that--market value, book value, fair value, accounting marking to market. How do you put a number on that? But the denominator of that is always risk-weighted assets. And so the big issue is how do you figure out what the risk-weighted assets is.
7:22 I'm asking a simpler question. If I'm a bank and I have to have 10% capital, what does that mean? What it means is that they would look at your balance sheet in some periodic way and they would make sure that you have that. If you somehow go below that then they will start intervening or something like that. I have to comply with that requirement. The innovation of Basel III, which really is an important innovation in principle, is that there is a conservation buffer. We saw in the crisis is that two of the requirements themselves can create a certain dynamic by just having to comply with them. So, if you always have to--the buffer cannot be a buffer because you can never run it down. So, if it's supposed to be a cushion then suppose I have 20% equity in a house--so I bought a $1million house with $200, 000. Down. Down is equity. The reverse is being a subprime loan or being a highly leveraged bank, you put $20,000 and buy a $1 million house. That's 2% equity. And then the house value fluctuates--like these mortgage-backed securities, that kind of thing. As it fluctuates, if it goes down, I become sort of distressed. Insolvent. I can go under water because my assets will be worth less than my liabilities--I will have negative equity. In that case, if I need to comply with capital requirements, I could try to kind of salvage it by selling part of the house. This was sort of the fire sales that we saw the dynamics of that where we are sort of deleveraging--in order to maintain 1% of the assets as the assets go down, you need to sell the assets quickly. And if the assets are illiquid that creates a whole dynamic of selling. Or if everyone has the same kind of asset. So, everyone is trying to sell the same thing at the same time. And partly it's to comply with the requirement. It creates this kind of deleveraging cycle, vicious cycle that was kind of saw play out among other things that we saw in the crisis. So, the idea of the conservation buffer is the story that my friend Charles Goodheart, who is a banker, a banking expert in the United Kingdom likes to tell is sort of about the taxi cab in the station: you have a requirement to always have a taxicab at the station; and when you get there at 3 in the morning the taxicab that's in the station cannot take you anywhere because then there won't be a taxi at the station any more. So, basically the buffer is that you have 7% at normal time, but you can draw down on that, down to 4.5%. What happens within that buffer is you can't pay dividends; you have to conserve the capital when you are in that window because you are not in a healthy situation. You need to try to strive to get back to the 7%. Let's put the buffer to the side; but just to clarify this issue and to get some vocabulary: If I'm holding 10% of my assets in the form of equity and 90% in the form of debt, we say I have a 9:1 leverage ratio, right? Depends how you define a leverage ratio. Oftentimes, now they would say equity over total--so that would be like 10% leverage ratio. So the 3% they are talking about in the Basel III, 3%, is equity over total assets. So that's a 97:3 ratio. They don't usually do it that way. I know, but I'm doing it that way because it makes more sense to me. Debt to equity. There are various ways to measure it; so it's D over E, D over D plus E, whatever. Let's go back to the house. So that's $30,000 over $1 million. The house, let's say, loses 5% of it's value. You are under water. It's now worth $9,950,000; and I only have $30,000 in equity. Which means that--here's the part I think is confusing for some listeners--if I had to sell the house today, and it's current value is 10% less than what I paid for it, I would not be able to meet the loan--I could not pay off my loan. So, if it's a non-recourse loan, you can actually walk away from the house. Sometimes you would stay in the house because you have an option that the house might go up. So, it's under water and none of the money for a put option you still want to maybe wait for the upside. So, you still might want to pay the mortgage over time, in the hope it will go up. Or it's a pain to move; I might not want to sell the house because there are transactions costs. But you might choose strategically to walk away. And if it fell enough, if it fell 50%, I might say why do I continue to invest in this asset. So, that's a strategic default. It would go on your credit rating. But I might not have one anyway. But it might make sense to foreclose except if they had the documents, which is another problem.
13:07But, that's a house. If I'm a financial institution, a bank of some kind, I have assets of $1 million that I financed 10% with equity. I have $100,000 in investors that I've raised and I've borrowed the other $900,000. The asset, let's say it goes down by 15%, more than the equity. In that story, as we said just now with the house, it's true I'm "under water." But, I haven't sold the asset; I don't have to sell the asset. The problem becomes that the lenders might get uneasy, because their recourse--which is their collateral, is less than their claims on it. So they might say: I think I've had enough, I think I should get my money out; and of course I wouldn't have enough to pay them off. Then the government might come to help you. Correct. Which is a bailout. It is a liquidity support, whatever they call it--windows would get opened up. Well, they wouldn't come to help me. They come to help you, the lender. Yes; they want you to be able--either the Federal Deposit Insurance Corporation (FDIC) would kick in; if you are going to be taken over, the deposits would be taken care of by the insurance. And if I'm an investment bank, like Bear Stearns, it might be that the government simply creates a marriage between J.P. Morgan Chase and Bear Stearns, using the justification and guarantees the bad assets because they want the creditors to be happy. Or to create financial stability--we are not going to debate the real motivation; there are a lot of possibilities there. So, my question is: As an institution, as an investment bank, as an investor in such an institution, I like leverage. Why? Why do I like leverage? Explain to us why? Because leverage, as you pointed out--there are a lot of different ways to define it. But it's clear that say, between 1980 and 2007 there was a big change. In 1980 investment banks were "using their own money"--they were partnerships. What are the advantages to being able to borrow lots of money and why do you think it happened that it changed so dramatically over the last 20-30 years? The advantages of debt--there might be reasons here that we are not completely understanding, because when I talk to bankers there seem to be ways they think about it that don't make sense to me. From what I see as rationalities from their perspective are mostly subsidies of the debt. Debt funding is subsidized for banks through the tax code, which subsidizes everybody to have debt because interest is deductible. Debt on housing purchases. On everybody. Well, not on everything--I can't deduct. No, corporate debt. Okay, corporate debt. So, corporate debt interest payments are tax deductible. That immediately is the first friction we talked about in terms of how do you want to fund--there's a tax advantage to debt funding over equity funding. Just like right off the bat, this way of funding, debt, is subsidized. Literally. The total available to everybody becomes larger, which of course is the equity takes off the top the equity benefits; the debt holders come at the appropriate time, the present value to them, they just get promised the value of what their claims are and equity reaps the tax advantage of debt. So, the more leveraged, the more the tax benefit comes into that whole balance sheet. But corporations generally are not as leveraged as bank. Right; so now you have to ask yourself what's the difference with a bank when it comes to the economics of funding. That was basically where I came from, because I was never in banking; I know corporate finance. Why should banks have such a different structure than the rest of the world? Nobody has anywhere near this kind of leverage. And nobody almost can. That's part of the point. In the rest of the world we talk about tradeoffs between debt and equity. Yes, there's a tax advantage to debt, but there is bankruptcy costs and who is going to pay the bankruptcy costs. The risk of bankruptcy because if you can dissolve immediately there is no cost--it's just a change of ownership. But there is a sort of deadweight cost--lawyers will come in, there are all kinds of distortions in investment decisions that get made when equity makes a decision in a highly leveraged firm. So they start to take more risk; they start to have what is called debt overhang so they can't take advantage of good projects because nobody wants to come in when they have so much debt commitment. So, that's a natural set of balances. The result of this is lots of companies having incentives to gamble with the debt-holders money; it's like up we win, down you lose. They put covenants in, so any debt comes in with a lot of baggage--strings--you can't do this and you can't do that and you can't pay dividends and you have to go back to the debt holder. To get their permission. Because they are anxious about you making decisions with their money. We've said many times on this program--equity holders benefit with the upside. They can get wiped out, but the up side they get a big return. Debt gets a fixed return so the only thing they worry about is avoiding the destruction of the company. If they can't claim their principal, it has the result, that creditors--debtors--are the watchdogs of prudence. In a normal system. But that's not the system we have. Not in banks. Banks somehow, because so much of the debt of banks comes under an ever-increasing safety net, it doesn't work. The discipline does not work for them. There are many ways in which you can even understand--first of all, there is a certain way in which once you are so highly leveraged it's almost addictive. You are in permanent debt overhang; you always want to fund with more debt and you can't get out of there by yourself. Almost an addiction; somebody needs to yank them out of that place that they are, with 5% equity or however much into a much healthier place. That would be--we used to have. Thirty years ago. Or fifty or a hundred. It's not the good old days necessarily of everything, but it's the good old days of equity. You actually had to worry about things going below 25%, and it was your loss as equity and managers to bear.
20:44Talk about the safety net. Normally, in a normal American corporation, as the proportion of my assets that are debt rather than equity grows, that starts to introduce a great deal of anxiety in the form of other debt holders. Agency problem. What is going on in the bank world that has made that restraint loosened or nonexistent. Well, first of all you have deposits. Deposits are insured with FDIC insurance. That already takes care of a big chunk of the bank's debt that doesn't worry about anything. When you even have models in banking, say, the depositors are going to threaten to run or something, that's not a credible threat any more because they are insured to $250,000 now. In fact, you can get around that because you have deposit brokers and they place as much money as you want under deposit insurance these days. So, the FDIC is there for a large chunk. And it's not just that. If you want to play the yield game and go and have money market funds that also supposedly have guarantees and go out there and explore, the minute something seems wrong, there you are back in the deposit sheet world. So, all of a sudden the balance sheets of the banks with deposits swelled in the crisis because everybody wanted the safety of insured deposits. So that's something you always have--you can move the money back into the safety net. Very quickly. And all of a sudden, voila, you are insured. You can go to multiple banks or whatever. So, the system is there to make sure that you never lose as a depositor. That's true for Bank of America and for Citibank--on their banking side. Let's talk about investment banks. What happens with investment banks--to the extent they exist. Well, they don't exist; they are all together. So, it's universal banks that we have now. Everybody's a bank. Banking holding company, Goldman, is a bank. Everybody likes to have the access that banks have to the Fed, the discount window, to all these liquidity supports that will always be there or supposedly be there. What effectively happened in the crisis--one of the worst things that happened in this crisis--is that the exact opposite of what was supposed to be the lesson of Lehman. The lesson was supposed to be that here we are, we are going to let you fail; we are not going to do what we did with Bear Stearns. Instead, they let them fail; within 12 hours it was a big mistake. The conclusion was they shouldn't have let them fail, because look what happened. The second guessing of that is large; but the bottom line of that is everybody became a bank and so the largest one, it is the received wisdom in the market, including credit rating agencies and everything no matter what Dodd-Frank says, that they will not be allowed to fail. They could not be allowed to fail because it would create all these problems. And just to review from past episodes: the Bear Stearns rescue in March 2008 was a rescue of the creditors of Bear Stearns. The equity holders got wiped out. This allows the government to say: We didn't bail everybody out. But what it continues to do is subsidize leverage. Because leverage doesn't charge the right price. Because it's safe. Usually there would be a risk premium or extra yield because of the risk.
25:09So, let me ask a question about the weird world of investment bank lending and debt that is a little bit different from the world you and I live in. A lot of their borrowing was extremely short term. That is, one day. Overnight. Hours. So, what Bear Stearns was doing was borrowing a lot of money overnight using what turned out to be not-so-hot collateral, which was their mortgage-backed securities. Why did it take that form? What was the advantage to that world--I don't understand that. It's a piece missing from my story. The short term debt has a liquidity to it, a demandability to it almost. People like it. They like to place their money overnight and play with it. They don't like to let it sit even hours. It's supposed to be this self-perpetuating way, this renewable debt. What basically happens with short term debt--we have even models of that--you always have incentives to maturity rat-race that you get. So, by making debt shorter and collateralized you always have--it is essentially a conflict of interest where if you have debt, equity always wants to issue debt that's equally senior. Or more senior than existing debt; that takes advantage of the seniority that's already there. It's very similar to taking risks on their back that they didn't. When you have some debt in place you always have the incentive to kind of take on a little bit more debt of a shorter maturity. Why? Because those debt holders will not demand--they feel very secure. So, they don't demand a lot of interest. Because they are very senior at that point. Oh--in case of a crisis they are first. Because they can pull the money out first. Because their claims are payable sooner. Sooner is more senior basically. So, it creates a situation where you have an enormous maturity mismatch in the sense that the assets themselves are very long-lived and the liabilities are extremely short term. The short term funding is very fragile because the minute that these funders have any suspicion that there is going to be a problem--they are out. But that's the puzzle. Because if you are right--and I basically tell the same story--if we are right that the safety net encourages debt rather than equity, then why would I be so worried as to only offer overnight funding? It's a [?] form of debt. There is sort of this demand in the market just like there is demand for deposits, for this short term debt; they'll do any debt that people want. As long as it's debt. The key is that it's debt. Once you are promising to pay and you are under a safety net, your funding cost is cheaper. Debt of any kind is good. But why did it overwhelmingly take this form? Because that was the way commercial asset backed securities and the way money market funds wanted to work. But the puzzle is why? You'd think you wouldn't need to do it overnight. We're not talking about six weeks versus six years. We're saying overnight. So, if I'm going to get my money back because the government is going to bail me out, why is it that the market produced this world where so much of the borrowing and lending took place overnight? I think people want to have access to their funds, all these liquidity need. True. So you have payment systems and businesses that just like that liquidity. They like to work in that way. There is a lot of money that wants to be parked for a very short time. It gives you a nimbleness, a flexibility. It actually doesn't. It's a very fragile funding system. And that's the problem. What we are saying is: if people really like that because they have utility out of that liquidity like deposits and we like to know the money is there and we can get it out, then that's fine; but they can back it up. Do whatever your business wants to do at the right economic price. Once you own the downside of that and you are not relying on the safety net, then fine.
30:45So, let's go back to your suggestions for the future. First, just to summarize where we are now: Basically, what we're saying is--and there's nothing controversial about this at all--that when so much of your balance sheet is debt rather than equity, small changes in assets--which were impossible because they are so safe but that turned out not to be so safe--create an insolvency or impending bankruptcy. Or even just distress and therefore refinancing problems. And as a result, you get the problems that we had. To prevent that, I would argue that we should get rid of the safety net. So, you are going to take a different approach. You are going to say: We are stuck with the safety net. I'm going to reduce it. Tell me what you are going to do that will reduce the probability of the next crisis. The way in my mind, the most cost effective, simplest, most direct way to address not just one problem but multiple problems is to reduce the safety net; it would improve the [?] decisions that are made, shift the risk where it should go. Take out the distortions. And align everything better--is to dramatically restructure that side of the balance sheet. The proposal, the Volker rules and ring fencing and breaking--that is on the asset side, split them, make them smaller. We could then let them fail. But then you'd have a lot of small ones that are still highly leveraged; they'd still be interconnected and still have a domino effect and fail. The key thing first is to structure--the change we are proposing is a very simple change to the system, which is essentially reshuffle the claims in the economy. Everything is still held by the same end investors. But what we are doing is there is a lot of risk capital and equity capital that is out there; and there are all kinds of debt commitments in this market. So, if you look at the big picture, we're saying there's too much debt-like stuff and too little equity-like claims in this financial system. We need to make that system owned and funded by a lot more equity. There is as much capacity as people need to for all kinds of debt, issued by lots of incredibly well capitalized entities out there. Apple can effectively issue Treasuries. They have 100% equity funding in Apple. 150% equity funding because people owe them. They cannot fail because they aren't owing things, financial claims. The average company publically held is 70% equity. Here we have 95% debt, 5% equity or something. So, the idea would be if the safety net weren't there--if we didn't subsidize debt--firms would naturally in the marketplace through their own self-interest be forced to be much less leveraged. Maybe not 70%. Look at real estate investment trusts (REITs)--30% equity. They don't have a safety net. That's just a benchmark. Nice point. So, the argument would be we should have higher equity requirements for banks. Isn't that what we've had all along? The whole Basel I. The numbers are tiny. So you are suggesting--a whole different order of magnitude. Barely get to two digits and even that based on risk-weighted assets. I'm talking about even adjusting for risk in some fashion, balance sheets have to be somewhat monitored for risk taking on the asset side, but based on where we are today, I don't begin to see the social cost of having 20-30% or arranged between 20% and 40%. Gene Fama said 50% sounded good to him; no problem; what's the problem? The problem of course is political. Economically--that's what he meant; that seems like a healthy system to me. There are two issues of course--political and economic. They'll get tied together. The issue being strangely enough that banks don't like that kind of idea. And in fact in the current world we are in where Dodd-Frank is sort of in force--it's not fully fleshed out. There have already been stories that, say, Barclay's changed the way they've defined something because "they didn't like all that capital sitting around." Trapped. Tied up. Imagine a little cage. All these metaphors. I don't understand, and we'll put it on the web--slide show presentation that Anat put together. And other slide shows; technical papers.
36:26Let's talk about this tying up, not working idea. And let's put it in the context of Bear Stearns and Lehman. So, my claim--and some people agree with this--is that it's not the failure to rescue Lehman Brothers' creditors that was the problem. It was the decision to rescue Bear Stearns. That when the Fed did that, and orchestrated the marriage of Bear Stearns and J.P. Morgan Chase by guaranteeing the toxic assets of Bear Stearns, they sent a signal to the market which was a very powerful signal that said: If this happens, don't worry. I've tried to look at, with modest success, not much, what happened to Lehman Brothers between March and September of 2008. Because if Bear Stearns had been allowed to go into bankruptcy and all its creditors wiped out or had to take a serious haircut, my presumption is that Lehman would have had to continue its operations in a different manner. In particular, when Lehman failed, Reserve Primary, a money market fund, broke the buck, which means they did not have enough assets to cover their promises--if they promised a dollar. Which is a little bizarre, because why would a money market fund be lending money to a firm that is as risky as Lehman? The answer is obvious--because they were getting a good yield. But they yield's not worth it. They'd say: Hey, we're probably going to get rescued. So, my question is--this is a practical question--what could Lehman have done in those months? If the government had come in and said: We made a mistake. We shouldn't have rescued Bear Stearns. And we're going to impose, without legislative authority, a higher capital requirement because you look like Bear Stearns. Your balance sheet is way too leveraged. Your assets are way too risky, and I want you to change your equity-debt ratio. What actions could they have taken? One critical thing they should have done--and this is true for all the banks; and we know that now, it's so in-our-face that it's crazy--from 2007 on, they should have stopped paying those dividends. That was criminal that they were allowed to pay such dividends. Through the crisis banks were allowed to pay dividends in this country until 2009. They depleted their equity right there. Dividends are payments to equity holders. So they reduced the amount of equity that is there. If you retain your earnings, that's equity. The equity backs up the debt, and that's what they don't want to do. Any dollar in dividends is a dollar that can't back up the debt. The easiest way to raise capital is internally. How much would that have? I haven't looked at those numbers. There are papers that looked at the dividend payments over the decade before; and I wrote pieces on the dividend because this was one of the worst things that happened this year was that the banks were allowed to pay dividends. But the standard phrase that is used in this situation, which I think is related to your ideas, is: they needed to "raise more capital." What's the physical--logistics? Issue stock? How would they do that? Same question as: How do we go from the world we are living in now to a world with more equity? The first thing is to retain equity. There are earnings now and they keep wanting to pay them out. And that's exactly what they should be stopped from doing for a while because the easiest way to do this is not to go back to the equity market but just retain what you've got. The other thing is to raise more equity. What you need to do is basically to do a right offering, meaning you basically offer more to your investors potentially at a certain discount and raise the money from your current equity; or you go to the equity markets. What might happen as a result, if you retain your earnings or go to the equity market is that their stock might go down. That's one of the things they really hate. But the only reason for that, if we don't change anything else, don't change the taxes, and we of course we are trying desperately to remove the implicit guarantees as well as we can--is you lose some subsidies. From having less equity to having more equity, the safety net and tax benefits are lost--you are taking away subsidies from an industry. And they hate it. They can scream. But who is going to buy my stock? Everybody. The same investors that own everything. At a low enough price people will hold it. Sure. You have to offer it at the right price. But isn't my equity going to go down? No. In the bigger economy these adjustments are minor. These are reshuffling pieces of paper. The question is what will the bank do with the extra equity. What will happen to their asset side? One thing--they can lend. They can't complain they can't lend. This is the most central issue that I think everyday people--and this economist--sometimes struggle to understand. They don't put the money in a box and bury it in the ground. When you invest money in a house, it's in the house. The only difference is the source. The only difference is you are funding the same thing. You are doing the same thing on the asset side. Potentially. You can do the same thing. I'm not restricting you. Not reserve requirements. I'm not restricting the asset side at all. Not touching what you do. You do what you find value doing. Creating value. What I'm only changing is the way you fund those investments. The way you fund those investments, instead of promising people, just have them join in as equity. That's all we are doing. It's the simplest thing to do. It just says: Why only 5% of your investment is funded in this way? Why not 25%? And of course it would change what you invested in because you'd have to convince people the merits of it. Exactly. Then you'd make better investments. The whole point that we are making is that, quite the opposite of saying that this should restrict lending, it would make lending better. Not every loan is good. We saw subprime loans that were not good. We want good lending. So, credit booms. What we want is economically appropriate lending.
43:44Coming back to my earlier point: The last 20 years of bank regulation, which "innovated" the kinds of capital, different ratios--what you are really saying is we need to create a much larger number as a minimum in a big range. And in that range you kind of let it suffer some losses and you build up capital--so you don't let them pay dividends when they are between. All kinds of challenges and all kinds of details there; we are still at the level of a lot of nonsense. But say I'll dream up numbers; say they are arbitrary. Not science. Say my numbers were between 25 and 40% or 35%. In that range, you don't pay any dividends. You can go a little down, and when you build back your capital, then you are healthy and you can go on doing everything you do. What will happen to the size of banks? My point is they will get to the natural size. Smaller. That's how companies' sizes are determined. I am not regulating size; I'm regulating ownership structure. Going back to the Lehman example, or any distressed bank, or making a transition from the current world to the world you are suggesting: the other way of course is to sell assets. Correct? Yes, you could do that. And if you are trading assets and anybody could hold them, no reason for these banks that are under the safety net to be the ones that own them. Actually, I'm not sure what I said is right. Say I have a fixed amount of assets and I have a certain amount of equity and I have debt. I could sell assets to pay down debt. So, that's one way. So, in our paper, we have three ways to control the capital requirements. Dividends? No, no, no. I'm saying statically. You start with statically first. In the balance sheets you have 5% equity. One thing to do to have more equity as a fraction is to scale down. That's what they say they would do. Supposing that all their assets are so valuable that they would have them, then that's to tell you that credit will go down. The point, by the way, about that is: banks are not the only ones who lend. And they don't have a monopoly on lending and I don't mind that anyone else lends. Now hedge funds lend; now peers to peers lend. There's all sorts of lending that are better funded than the banks. So, they don't have a monopoly over lending. People who are not systemic can lend and there is no restriction on lending. I think as you said, in something I read of yours, that's a feature, not a bug. There's too much lending. Potentially. I don't know. But right now there's not much lending. Right now I think we are in a credit crunch, but it's because our heavy leveraged already, and because we prefer to do other things so the risk weights can distort it. Because what happens is, the risk weights, when you have sovereign debt with zero risk weight for [?] securities, zero risk weights as if they are riskless. Well, we know that's not true. So, when you measure the risk and certain assets get very small risk weights, then you are attracted to them because they allow you higher leverage. And so lending is sort of fully charged by their length. So now it is in the United States what you see--they don't want to make bigger loans. That's too much trouble. They have to monitor them. They have to work. What they like to do--they go to municipalities. Lower risk weights, probably. That's the equivalent of going to sovereign debt. They invest in hedge funds, now. They woo hedge funds. I have lots of stories about that. They have so much cheap money right now they don't know what to do with it. But let's talk about that. We might want to get into this. The banks right now in the United States are holding very large excess reserves. They are doing nothing with it. They are not buying municipal bonds. They are trying to buy things. They need stuff. But going back to our question about sitting around--they literally have money sitting around. They might. But right now the banks in the United States have all kinds of lurking issues. They've got a lot of problems with second mortgages that aren't recognized. They've got all kinds of issues. There are loans that are not performing that they are thinking that the federal housing authority would cover, which Deutsche Bank got into trouble with the same assets that the federal housing authority said they will not cover because they don't qualify. So, you think some of the reserves are being held as a cushion against a disaster? And also the foreclosure papers that they don't have. Which are still lurking there. So, they have a lot of things. And still foreclosures in Europe. And what are they doing with this? Depends. I am not an accountant, so I actually don't look. People who have looked at that who I've talked to think that there are some troubles there. All kinds of things you see them do that make you think: What's going on? Trading assets that yield something that have relatively low risk; why are they doing this or that?
49:14Let's come back to your idea. One of the things I like about it is it's simple. The risk-weights also are complicated. Formula also they give them a lot of latitude to calculate things based on their own risk models, which is a temptation to manipulate them. So, for those of us who are worried that the financial system is a bunch of cronies who are manipulating the system to their advantage, what are the odds that a simple idea like this, which is politically, even though challenged by the crony problem, dramatically easier, more credible--to me more preferred to the alternative, stop bailing out creditors. I can talk to that because I know about resolutions. One of the things that Dodd-Frank did and one of the things that probably is a good idea in general, although you really don't want to rely on it, and that's what Sheila Bair is saying we are going to resolve and all that--the FDIC is very good at resolving small banks. Resolving a city is going to be a mess. First of all, deciding when to start doing that process is already challenging. How do you get your hands around a trillion dollar bank to know? When you say a city--you mean a city bank? Yes. Essentially doing a bankruptcy process to them that is somehow better than a bankruptcy process. You are talking about. The resolution authority. I interviewed Vincent Reinhart, who made the observation that the only creditors that took a haircut in the mess were either Wachovia or Wamu--I can't remember which one--but they went through FDIC. Everybody else got 100 cents on the dollar, through Treasury. Anyone who was promised anything got it. All the cushioning that was not equity was useless. The whole notion of loss-absorbing debt--now you are talking about debt. What's the up side? They just get debt to lose and they are not going to like it. Their legal problems with it are huge. If you have a global bank, legal systems are very different in different countries. Doing a resolution of a bank that has 100 countries or 70 countries and can move the money between countries--we are not at a place where we can do that easily. And we've tried this before. We had Federal Deposit Insurance Corporation Improvement Act (FDICIA), which was supposed to be a takeover by the government of the management of a bank that was in trouble, and it wasn't used because it was politically unattractive to enforce it. The banks have grown so much and have become so complex that we just have to really focus on prevention, basically. It's very important to not have bankruptcy as just being the way to go. Resolution is important and I think the FDIC is really the best agency around in terms of worrying about taxpayers. It's good that they got to play here. But they are not really--nobody is really in a position to be able to handle that very easily in a systemic event--to have multiple failures potentially or distress. And the banks saying: Just give us assessment, we'll pay for our own resolution. That's exactly when you can't give them an assessment. That's when you give them Troubled Asset Relief Program (TARP), when you start supporting their capital. Not the time for them to start paying for each other's resolution. You know they are really problematic scenarios and all the resolutions take a lot of time. And meanwhile the system is frozen, and all of that. The government--all the "read my lips, I won't bail you out"--nobody believes. So the problem is--they probably will change the law and find a way out.
53:17So, what kind of reaction have you gotten for your proposal, your idea? I have to say, depends where you are talking in this world. The best people on this, although they have their own politics, is in the United Kingdom. The best people talking in this space of the people in these countries is Sweden, for example. But the United Kingdom has everyone focused on this. Now, they have bigger and dangerous banks. Ireland is nearby. So, they are scared. But for our banks to say: Oh, it's going to be a level playing field; let us be as big as them or whatever--that's not a good thing. In this country, it's not a good thing. As Bair says, it's not a national objective that our banks can go playing against some other banks. What's in it for me to back them up? Makes no sense whatsoever. First they own their decision; then I'm happy for them to go compete. If there is no safety net then I'll cheer them on. But if it's a safety net, then I care that they don't go to 100 countries to play around and get the upside and leave us with the downside. So, we care. In this country, I'm very sorry to say, it's been more than a year and now, occasionally I would get to talk to a few people, but it was a war that nobody wants to hear this. No, because they like to play. Very, very frustrating getting through. Even the newspapers. Now, the Wall Street Journal, all of a sudden is in favor of this. But they certainly didn't take my op eds for a while. They give you a lot of reasons for that. They give you no reasons. I know they don't. But it might not be because they don't like it. Whatever. I stopped wasting time on that because I wasn't getting anywhere. No way to get through. But they are more interested now than they were before? Well... a little more pressure in this country. But the truth of the matter is it's not been serious engagement in exploring what we are saying and whether it makes sense or not. There hasn't been. In a whole year of doing this, I've been unhappy with the level of engagement that I've seen. The problem is--I don't remember if I've mentioned this on the program before, but somebody asked me the other day, wondering why--this was a prominent international bank person--why is it that the banks were being so politically influential despite their lousy performance? I think the answer, the Willy Sutton answer, is: That's where the money is. It's a little bit of a frightening Ponzi scheme, where the government sends money to the financial sector; the financial sector gives it back to the politicians; and they are scratching each other's backs. And it's not a partisan issue, unfortunately; I wish it were. Across the board. What really disturbs me is that outside of our profession--I'll call our profession academic finance and economics--most people are disgusted by it. We are, to some extent--not me and you but academic economists--have been the cheerleaders for justifying this last two years of subsidy. The average person is disgusted by it, and yet the political power only moves in that one direction. It's probably better that we got to the end and I don't get to talk about some of these things, because I've been also disappointed in some of the academics just not picking up. And just because in some cases, if somebody wants to hear something you give them what they want. That's the way it works. You want to be a player. You don't want to argue, you don't want to fight; it's not fun to be contradicting. This industry has been way too involved after what they've done. There are a few ex-bankers who are very honest. John Reed, Herb Allison--these people are going to say it as it is. Because they are not on the.... You know what precisely sums it up. I've thought of versions of this before, but this moment really crystalizes it for me--it's called Dodd-Frank. Of all the people to champion the reform are Dodd and Frank, who helped create a huge chunk of the problem. And the fact they had just a seat at the table with those bankers who should have had no seat, no voice, should have been shut out of Washington--you've misbehaved; we gave you candy and you now are going to have to go play by yourself by a while. We'll tell you when you can come back in the room. They're sitting at the same tables again. They are testifying again. I was sitting right here steaming at J.P. Morgan executives going again before the Congress and here I am in California. I have more sensible things to say, and yet he gets to go testify. How does that make any sense? But that's the way it works right now. Really very frustrating. I don't know. Well, we try to spread the word with programs like these, but of course my view is that anything that curtails the discretionary power of the Fed and the Treasury is a good thing. And although that's unlikely to happen for all the reasons we are talking about, there is more political momentum in that direction than ever before. I think that's a good think. I just want to say one thing. There are a few things in Dodd-Frank that are sensible. I think in principle the consumer safety is a good thing. I disagree with you, but that's okay. A lot of information that I've seen--I've seen some forms where supposedly I was informed and really confused about. When Elizabeth Warren said there's more information about [?] than about financial contracts, there was a point there. There is consumer protection you can do there. As she has been trying to argue for a year, not necessarily hurt. I think the Office of Financial Research in principle could give information. In theory. More information is good. But again, I'm not that optimistic that it will do what it's supposed to be doing. Meanwhile, I agree with you that it creates--in terms of what I'm talking about, what Dodd-Frank did was it created Financial Stability Oversight Council (FSOC)--the group of all the regulators--to monitor systemic risk. So, in principle, the law did not say how much capital requirements should be. It delegated it to this group. So the only issue is: Are they doing anything? Guess who is going to get a lot of attention and guess who is going to be attending? Exactly--the banking industry. So, this particular group of regulators, if they are not going to do it, then it is just delegated to them. That's where I am.

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COMMENTS (25 to date)
xian writes:

great stuff econtalk...

u guys sounded a bit like charles ferguson of "inside job" towards the end when u were noting how economists were in on the mindwash of "yeah. it's great. it's markets and bold risk takers blazing the trail of john galt" (ok exagerated)

she was a great guest.

Mads Lindstrøm writes:

The podcast touched upon the problem with putting multinational banks into bankruptcy. Another problem with multinational banks in EU, is seen in my own country Denmark. Denmark is the only EU country forcing creditors to take a haircut when banks fails (E.g. when Amagerbanken failed). However, foreign banks operating in Denmark are not under the same constraints, as other EU countries will bail out creditors 100% should some bank fail. It is properly not a big problem in Denmark, but it obviously creates a race to the bottom among European financial authorities.

A solution to the problem with multinational banks, would be to force banks operating in foreign countries to open a subsidiary. There should be no financial ties between "mother"-bank and subsidiary, except for the mother-bank owning all stocks in the subsidiary. The subsidiary should operate by local laws, and if it fails it should be bailed out (or not) according to local laws and paid by local authorities. The mother-bank should only be able to take money out of subsidiaries, which were in a healthy state.

Forcing banks to make subsidiaries would make bankruptcy easier, as one could either sell subsidiaries on the market (maybe to other banks or as an IPO) or one could give creditors stocks in subsidiaries as part of their payment. Forcing banks to make subsidiaries would also eliminate the race to the bottom by financial authorities.

Scott writes:

Great content, though it did seem a bit more "free-form" than other shows and therefore a little harder to follow.

Do investors really appreciate the Modigliani-Miller capital theorem? As a bank regulator, everyone I talk to on both sides of the desk seems locked into the "capital is expensive" mindset. If you try to suggest otherwise, people tend to look at you like you've just spontaneously grown a second head.

I did like that point that, at the right price, someone would be willing to put in the needed amount of equity. The difficulty will be the sea-change in investors from those that want high returns on equity to those that are willing to accept less. There are a few banks in my trade area that have 25 percent equity to total assets, so I know what Ms. Admati is suggesting is possible on a smaller scale.

Keep up the good work, and thank you for a great program.

Ravi writes:

The link to Anat Admati's page goes to a bad gateway error page.

[Well, it says it's down for maintenance. The page worked over the weekend, so I think we should give it a little time.--Econlib Ed.]

walt writes:

Very knowledgeable guest! Shame that she talks without stopping and literally starts screaming whenever Russ Roberts tries to guide her. It's better when the guest plays along and is more conversational.

Still, thanks for the good cast -- really enjoy it when more technical experts are featured.

Justin Dugger writes:

I assume it's because of checking rollovers.

Technically, demand deposits like checking aren't lent out. All the money I leave in checking is just sitting there. In theory. In practice, all the savings and loans are allowed to lend it out for extremely short durations: overnight. It's free money to the S&Ls, and so few people besides investment banks can execute on it that they were probably about the only buyers.

Now sure, its riskier, but show me where risk is quantified on SEC disclosures. In contrast, borrowing costs are gonna show up in bright lines, and overnight is the cheapest out there.

Manny writes:

Great guest; very engaging. Improved my awareness of banks and the incentives they have to make profits at any cost. Our lawmakers should be more keen on these ideas (Maybe they are but have other agenda.)

Hope you invite Ms Admati again.

muirgeo writes:

Excellent discussion Professor's. That was eye opening and very informative.

The financialization of our economy in a nutshell. The next time some one tells me that as a progressive liberal I want to transfer wealth from those who earn it to those who do not I will reference this podcast. Our finance and banking system has been turned into a Casino.. and the Casino ALWAYS wins.
We don't need less planning and less regulation... we need better planning and better regulation. Unvested people like this brilliant professor and her ideas are simply squashed by the power of money and the money changers.

JPIrving writes:

Walt was spot on, I had to stop listening because I found the guest's conversational style abrasive and almost rude. I couldn't stand how she constantly spoke over Russ and tried to finish his sentences (often wrongly guessing what he would say). She also spoke far too quickly and generally had an unpleasant voice.

This was a shame because the content was highly informative.

keatssycamore writes:

That was awesome. It was so informative that I listened twice. Thank you EconTalk!

And contra a couple of commenters above, I appreciated the guest's ability to cut to the chase and her refusal to follow Mr. Roberts down his sometimes long-winded and idealogical rabbit-holes of digression. Doing so cut out a lot of general "regulation is bad" back-patting and made room for her to be very specific and informative about what she believes can be done to reverse the destructive financialization of our economy.

Don't know if she's completely correct, but appreciate her ideas getting this exposure. Thanks again to Roberts and crew.

Ole writes:

A GREAT show!
I had to listen to it twice because Admati talked very fast and if i wasnt concentrated I had trouble following the reasoning. After listening to it the second time i see that she talked with great clarity and insight about banking.

The biggest insight i got from the show was the fact that state guarantee on bank depositors money is a major issue since we wont act as watchdogs over the banks business as long as the state guaranatee our savings. It also makes me wonder what happens if the deeply indepthed states in the Western world are no longer able to support their promises to savings guanrantees except for using the Mugabe-solution of printing money.

The only part of Admatis explenations I found doubtful was the idea of having equity requirements of 30 % or so or above.

For one, there is a race to the bottom all over the world. Money will flow to the countries with high leverage in banking, relaxed regulation, state guarantees of savings and low taxes. The whole financial sector in New York will n shrink apart with these levele of leverage.

Secondly, there is the point of banks creating money. If banks are having 40 % equity requirements, wouldnt it mean that 40 % of all investments in the economy go into banks? Or am i missing something? I mean if for every 10 dollar i save or borrow in the bank, another guy would have to to buy new bank stocks worth of 4 dollar, wouldnt that make the whole banking sytem very cumbersome?

Also dont see how the develeveraging will take place without shrinking the money supply in the economy and thus create a second depression. Because deleveraged banks means less money in circulation, and less money in ciculation is considered a major cause of the great depression.

Just my thought on the issue. Please correct me if im getting the leveaging issue wrong. Thx.

Robert Wiblin writes:

Great podcast though it might be good to give Adamati some feedback on radio/podcast style interviews in future. Like others, I found she spoke much too quickly. Talking over Russ, even to say 'uh huh', makes it hard to listen to. She also should have taken more guidance from you on the level of knowledge of the listeners rather than rushing ahead.

Enjoyed a great deal nonetheless.

Maribel writes:

She talks too fast!!! Good talk though, love your interviewing style Russ, I appreciate you trying to keep it simple for us amateur economists. You should pitch your show to PBS and make a TV show about economics for the non-economist, I would watch it every night. :)

Mr. Bankerman writes:

Among the problems with Prof. Admati's line of reasoning, the most direct is the simplest: why hasn't the banking system she describes emerged on its own without regulation?

Most economist accept and explain emergent order rather than attempt to explain why the order that emerged is bad and their theoretical engineered system is better. Finance is the great exception, and is part of the reason why academic finance theory is completely disregarded by actual businesspeople.

If shareholders are indifferent between the level of leverage at banks, why are there no material professionally run banks with 20% capital ratios? Agency costs alone account for overcapitalized balance sheets in a host of industries, and yet somehow those pressures do not shift into banking. While Prof. Admati and others focus on the asymmetric return to manager from debt, but that incentive exists in every single industry and yet is only a crisis in banking for some reason that Prof. Admati is unable to explain. Why are bank executives so willing to risk their reputations and multi-million dollar salaries to make their shareholders richer? Why is such altruism limited to the banking system, unless the banking system has many structural reasons for accepting and managing that level of leverage.

If shareholders are indifferent between the level of leverage at banks, why is there absolutely zero relationship between bank leverage statistics and valuation? Wouldn't low equity/assets banks consistently be valued at higher price/earnings ratios? Why does this relationship not exist in normal periods?

Sound policy balances actual costs against actual benefits, not costs hypothesized to equal zero against over exaggerated benefits. Higher capital ratios clearly bring some costs: otherwise banks would routinely operate with these high capital ratios. Dramatically higher capital ratios at regulated banks bring fairly small benefits: the US Treasury made money on the "bail-outs" of regulated banks and the most costly failures were of the completely bizarre GSEs and the completely unregulated Lehman Brothers. Balancing cost and benefit requires careful empirical work, not slapdash theory based on over-idealized reality.

My critique is best described by a single statement Prof. Admati made about a quarter into the podcast: “[bankers think about debt in ways that I do not consider rational]”. Forget the fact that Prof. Admati self-identifies as someone with little understanding of banking institutions and accounting. Like missionaries of old that shed the light of reason on the poor natives, Prof. Admati deigned descend upon the idiotic bankers to shed the light of Modigliani and Miller/EMH. The banking industry does not ignore Modigliani and Miller/EMH, we mock it because it is so disconnected from the reality we see every day.

Now that I have my rant behind me, I think it is productive to point out three areas of common ground:

1) As long as there are corporate taxes, equity financing will always be more expensive. The expense of taxes may come out of ROEs, but for a semi-commodity like most loans/deposit taking, that expense will come from higher borrowing rates. Any honest discussion must make this fact, and its implications for economic activity, clear.

2) Capital is scarce, and it takes human action to optimize capital allocation. While Prof. Admati may scoff when actual business people refer to capital as "locked up", in real life capital is often in less efficient use than it is in other places. Often time, capital is "locked up" because it is in one use and cannot take advantage of an arbitrage in another use. Often time capital is "locked up" because it is funding a good project and there is insufficient equity or ability to borrow for other projects. Any honest discussion must acknowledge that capital is more efficient in some places than others.

3) The actual social costs of the current regulated banking system is low or zero. The FDIC is industry funded and it is very hard to put together a scenario in which it would ever be a source of any loss for the US Treasury. Innuendo aside, the Fed's discount window enables very efficient capital allocation at no cost. The FDIC's Treasury guarantee and access to the Fed's discount Window are both worth something to the banking industry. Those benefits come with no costs to society and provide the public good of an efficient and competitive banking system. Why would we want to eliminate a system that brings free public goods? On the other hand, Lehman, Bear, LTCM, The Reserve Fund, and other examples demonstrate that the actual costs of the non-bank financial sector is very high.

4) At the scale of the global banking system, the way investors pigeon-hole their capital matters. While theoretically debt is just another form of risk asset, in the real world there are very powerful forces that compel investors to silo their capital. A fully funded pension with matched liabilities run by a conservative manager will not shift to equities no matter what the risk/reward. A small business will want to keep working capital in a completely risk free asset, regardless of risk/reward. Assuming that capital is fungible makes sense in small doses, but not when describing the many trillions of dollars in the global banking system.

5) The leverage that would theoretically allow some investors to replicate in their own investment portfolio the current risk/reward tradeoff available in banks would cause the same systematic problems as would exist in the banking system. Millions of individuals levered by fixed income investor to an identical outcome in equity markets would produce the cascading defaults that Prof. Admati alleges are the problem with the current banking system. Shifting the debt from one balance sheet to another does not change the outcome.

This podcast has an outstanding record of attracting interesting guests, but Prof. Admati is interesting in the same way a schizophrenic is interesting: it is interesting to ponder what must be going on in that brain, because she is just not thinking straight.

[This comment has been moved. It was mistakenly posted in a different comment thread. Also, the spelling of Admati's name has been fixed throughout (originally read "Ambani"). --Econlib Ed.]

John Berg writes:

Perhaps the best (and most entertaining) novel explaining the banking system is Neal Stephenson's trilogy which also covers the controversy between Newton and Leibniz and several other topics.

Two suggestions to help future podcasts (on which a dote) 1. Use a talking stick as we did in indian quides. 2. A specialized chess clock which also turns on each microphone.

I'll need a second hearing before I can comment.

John Berg

Teisha writes:

Thanks for the podcast. I think Admati's solution to the banking problem in this country is interesting would like to see it dissected by other economists, or attempted by policy makers.

I was also happy to see her remarks in the NYT today:

[Link revised to permanent link. Admati's remarks are on p. 2.--Econlib Ed.]

Robert Dell writes:

The assets of banks today are very real estate risk-oriented. Arguably today's banks are first cousins to REITs. But REITs, operating without distortive tax and government guarantee policies, are capitalized a lot like banks were a century or more ago, with equity typically exceeding 30% of total assets.

Banks might go along with a higher minimum equity requirement if that reform were combined with others that would boost revenue or reduce regulatory costs (which, for depository institutions, may well exceed the cost of corporate income taxes). For example, the phasing out of Fannie and Freddie and allowing banks to issue covered bonds for real estate mortgages would open up new profit centers for banks.

There'a a deal there somewhere!

Kevin C writes:

Mr. Bankerman,

You cannot seriously argue that our current banking system is truly emergent when every aspect of it is so distorted by regulation. I think it is impossible to make meaningful speculation on what that system would look like. But, I'm confident that this aint it.

Shareholder and depositors are only indifferent to leverage because they assume they will share no risks from that leverage. Without that guarantee, they would run screaming from the current level of leverage.

Reality is that bankers failed miserably yet again, kept their reputations and multi-million dollars salaries and shareholders got a haircut. What world are you describing?

Why is there absolutely zero relationship between bank leverage statistics and valuation? Wouldn't low equity/assets banks consistently be valued at higher price/earnings ratios? Why does this relationship not exist in normal periods? Virtually the same question as above. Because you operate in a system where leverage doesn't matter to people in the system. You slough those costs off on someone else.

As to your schizophrenic remark at the end: if your comments are any indication, I think you are vastly overrating your own thinking skills. This comment has the smell of political debate: disparage and discredit so that engagement isn't necessary. It isn't necessary to defeat an idea with logic and evidence if you can assassinate your opponent. This blog deserves better.

neoCONslayer writes:

[Comment removed pending confirmation of email address, for ad hominem remarks, and for irrelevance. Email the to request restoring your comment privileges. A valid email address is required to post comments on EconLog and EconTalk.--Econlib Ed.]

Joey Donuts writes:

One interesting point that was raised and requires some expansion, perhaps in another podcast, "there is currently a credit crunch, even though the banks have excess reserves." The guest brought up the fact that there are a lot of un-resolved issues in the banks, e.g. incomplete foreclosures and second mortgages that may be toxic.

How big are these problems? Have those that argue we are in a liquidity trap missed these problems. Does this fact imply that more "quantitative easing" may be effective? I would certainly like to have this issue explored more thoroughly.

Very good podcast, but begs a question: Why is Professor Admani so completely unaware of the fact that all steps suggested by her had been taken by regulators in Poland since 2006, and Poland was the only EU country that did not have any insolvent financial institution and did not experience a recession. How in the world are UK and Sweden any examples of good policy, when Sweden had to set aside something like $200 billion for bank bailouts in 2008, and U.K. took over Northern Rock, and intervened heavily. Good ideas, very bad facts.

Mr. Bankerman writes:

Kevin C makes a few common serious errors. Here are the most important:

1) To say that regulation prevents the emergence of efficient order misunderstands either the regulatory system or my argument.

Our regulatory system only sets minimum capital, not maximum capital. These minimum capital requirements do not do anything to prevent banks from holding as much equity as they would like.

My argument is akin to saying that a 55mph speed limit only prevents people from driving faster, it also does nothing to prevent them from driving slower. If a 30mph speed limit were sensible, we would expect to observe at least one prudent soul driving their car slower than 30mph on this metaphorical highway. The fact is that there are very conservative bank managers in the US, and none of them held as much capital as is mandated under Basel III, let alone the amount Prof. Admati seems to believe is sensible.

2) The claim that costs in the regulated banking system can theoretically be socialized may make some logical sense, but has no relationship with reality in the US.

- The claim that bank managers and equity holders have asymmetric payoffs that lead them to take imprudent risks substitutes actual incentives with a set of theoretical incentives that are not relevant in real life.

Bank managers have massive self-preservation incentive to obsessively avoid imprudent risk. A slightly higher ROE is unlikely to get them a higher paycheck while an angry regulator will get them fired immediately.

Equity cares deeply about avoiding imprudent risk because they understand that a period of losses will impair the franchise value of a strong depository. The franchise value of a network of economic branch networks is massive relative to the small spread that could be earned taking imprudent risks. No shareholder would ever knowingly imperil the perpetuity from this franchise value for any amount of temporary extra spread from risky loans. Note that this incentive is far lower for non-bank financials and weak depositories, which were at the epicenter of the bad loan problems from 2005-2008 .

The incompetent managers at WaMu and Citi sacrificed that franchise value for a very small amount of excess spread earned over two years. That bad trade off is why JP Morgan Chase, Wells Fargo, Bank of America (though not Countrywide) and many others stood aside and lost market share to reckless players during the "boom".

- Unsecured creditors and uninsured depositors certainly are sensitive to risk, just ask the bondholders in WaMu.

- Insured depositors are indifferent to leverage as they should be. It is impossible to expect ordinary citizens to be bank examiners the same way it is impossible to expect ordinary citizens to be building inspectors: both are highly specialized trades. It even seems that a professor of corporate finance doesn't understand banking, so how the heck would a surgeon or mechanic? If ordinary citizens were bank examiners, we would end up with the incredibly inefficient system we saw before the FDIC.

Mr. Bankerman writes:

The three things I ask all bank critics to keep in mind are:

a) Balance social cost and social benefit: The US has a profoundly efficient banking system that helps make sure that credit spreads are relatively low and depositors have incredible convenience. I believe that all these benefits come at no social cost, but even if you believe there is a social cost, any honest quantification of cost and benefit would show that social benefit massively outweighs the social costs.

b) Apply Hanlon’s Razor: Never attribute to malice that which is adequately explained by stupidity. This is especially true when your theory of malice relies on self-destructive and irrational malice. Were Citi and WaMu reckless because they thought they would get bailed our or because management was incomepetent? Would you rather have incompetence moderated by regulation or shoved into the shadow banking system were it could persist without check?

c) Remember that regulated depositories are businesses with a franchise that comes from deposits that allow them to operate branches. Just as nearly all businesses are worth more than its balance sheet liquidation value, banks have franchises that management and shareholders care deeply about protecting. That franchise comes from serving others: depositors benefit from ubiquitous branches and borrowers benefit from low lending spreads enabled by highly efficient financial intermediation.

Critics seem to think that regulated bank returns have to come from some sort of subsidy, when everyone close to the regulated banking business knows that this branch franchise is the one and only source of sustainable banking returns. That is why so many bank annual reports have big maps that advertise regional retail deposit market share.

As to Robert Dell's comparison of banks to REITs, I believe he is wrong on two essential points:

1) Unlike banks, which receive the same tax deduction on interest paid as every other business, REITs are the beneficiaries of a unique and distortive tax subsidy: REITs pay no tax as long as their return to shareholders meets a minimum standard. That direct tax subsidy is what makes a REIT a REIT.

2) REITs are capitalized with much more equity than banks because REITs are much less diversified and own a much riskier asset: the equity tranche in a real estate project. A bank levered 10:1 on large portfolio of loans at a 60% LTV is an order of magnitude safer than a REIT's few properties levered at a 70% LTV. To compare the senior secured debt that dominates the balance sheet of banks to the equity cash flow stream of a small set of properties dramatically understates the safety of the type of assets banks hold.

Mr. Bankerman writes:

As far as Krzysztof Ostaszewski’s comment about Poland's banking system... I would like to thank you for bringing up the prototypical model of what to avoid.

Ever wonder why General Electric, the maker of toasters, light bulbs, and MRI machines, has such a large lending business in Poland? I don't. Poland's regulatory system hobbles depositories, which increases lending spreads to a level that can support an inefficient capital provider, like GE Capital. Instead of efficient matching of deposits with loans, we have high loan spreads and relatively few services for depositors. Those high spreads depress growth and come with the additional feature of supporting an unregulated and profoundly too-politically-powerful-to-fail institution. Best of all, these high spreads would be even higher if Poland were a larger economy: this relatively small economy is able to import the small amount of lending capacity it needs to supplement its meager domestic lending capability. Spreads would rise much more if such a model were applied in the US or EU.

Why is GE Capital so much more active in Poland's financial system than in the US's? My answer is that the US banking system is so efficient that credit spreads are too thin for GE to survive.

Poland's only saving grace is that the economy has many structural elements supporting growth (i.e., a well educated, low-cost workforce adjacent to the massive EU economy). Those factors have been able to overwhelm the inefficient allocation of capital in its banking system (so far). Sounds like a model from which to learn important cautionary lessons.

Big Al writes:

russ: lots of great podcasts lately. i measure that by the fact thst i go back and listen to them several times over. thanks!

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