Business Week - Book Review

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Business Week - Book Review

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Business Week – 2/28/2013

With “The Bankers’ New Clothes,” Can Banks Be Too Safe?
By Peter Coy, Bloomberg Businessweek's Economics Editor.

The Bankers’ New Clothes, published on Feb. 24, is wowing critics of fragile banks with a simple and attractive message: Force banks to have much thicker cushions of capital and you can make them safer without paying any cost in terms of higher interest rates, less lending, or lower economic growth. At a Feb. 11 prepublication event with authors Anat Admati and Martin Hellwig at the Peterson Institute for International Economics, senior fellow Morris Goldstein called the book “the most important contribution to the analysis of banking regulation in the past 25 years … beautifully written and forcefully argued.”

The thicker a bank’s buffer of capital is—that is, the less it relies on borrowing to fund its operations—the lower the chance it will require a taxpayer bailout. Also, the easier it will be for the bank to keep lending and sustaining growth in a financial crisis. The extra margin of safety provided by more capital is a free lunch, argue Admati, a professor of economics and finance at Stanford business school, and Hellwig, an economist and director of the Max Planck Institute for Research on Collective Goods in Bonn, Germany. Says Admati in an interview: “What we are told—that you have to choose between growth and safety of banks—is just a false trade-off.”

Admati and Hellwig are getting a far cooler reception from bank regulators and the economists who typically supply them with research. Studies in the U.S., Britain, Spain, Italy, Switzerland, and South Korea have concluded that while banks do need to increase their capital cushions, there’s a point at which demands for more capital hurt banks’ ability to lend without buying much more safety for the financial system. Charles Calomiris, a Columbia business school economist who has long favored requiring more capital for banks, says Admati and Hellwig go too far. “When you increase capital requirements, it has an effect on the cost of lending. All things equal, it makes lending more scarce,” he says.

That’s a message that Admati and Hellwig have heard often. Douglas Elliott, a fellow in economic studies at the Brookings Institution and former investment banker, favors the higher standards of Basel III, an international accord to increase banks’ capital, liquidity, and supervision in stages between now and 2019. But in a working paper for the International Monetary Fund last September, he and his co-authors calculated that the Basel rules might raise average lending rates over the long term by 0.28 percentage point in the U.S., 0.18 percentage point in Europe, and 0.08 percentage point in Japan. A Feb. 20 article for Brookings made a veiled reference to the book, calling the free-lunch argument “a dangerous misconception” that “appears to be taking root in the public debate about bank safety.”

The dispute over The Bankers’ New Clothes is relevant to decisions about how high capital standards should be raised and how quickly. Basel III requires equity capital such as stock and retained earnings to equal 7 percent of a bank’s risk-adjusted assets. Assets are things like loans and bonds. The least risky assets, such as AAA-rated bonds, require less of a capital buffer. Admati and Hellwig argue that bank capital in the form of equity should be “on the order of 20 percent to 30 percent” of all assets, even the least risky.

Timing is another point of disagreement. Admati and Hellwig see no reason to delay higher capital rules. But the faster banks have to raise capital, other economists say, the more costly it will be to do so. The banks may have to issue more shares, diluting the equity of existing shareholders. To restore their return on equity to its target range, economists say, banks will impose higher interest rates on borrowers.

The Institute of International Finance, which represents the world’s biggest banks, concluded in a 2011 study that Basel III and other new bank regulations would cut annual economic growth rates by 0.6 percent in the U.S. and Europe between 2011 and 2015. Over the longer term, through 2020, the economic impact is much milder, indicating that while Basel III is useful, it should be rolled out slowly, says Philip Suttle, the IIF’s chief economist. As for Admati and Hellwig’s more extreme proposal: “I’m not sure they fully understand the picture,” Suttle says. “That would be the nicest way of putting it.”

Hellwig and Admati wrote The Bankers’ New Clothes for a general audience because they felt that they were getting nowhere trying to persuade the likes of Suttle and the formulators of Basel III. An omitted chapter, available on the book’s website, addresses their critics in more academic language. In an interview, Admati says the defenders of thin capital cushions base their conclusions on unrealistic assumptions about how banks work. “When I read or hear these arguments, my hair often stands up, there is so much nonsense,” she says. “The total cost to society of any changes must include the cost of having a fragile system.”

The ultimate objective is—or should be, anyway—to achieve the most safety and stability at the least cost to growth. Columbia’s Calomiris says banks should be required to finance themselves in part with a form of debt that automatically converts into equity if a bank’s finances deteriorate. These “contingent convertible” securities—known as CoCos—work like canaries in the coal mine, losing value at the first sign of trouble so banks have time to fix things. A more sweeping solution would be to eliminate the tax code’s deductibility of interest payments. That would make the economy more robust by reducing the incentive for banks and nonfinancial companies alike to put themselves in debt. Admati and Hellwig are right about one thing: Too many bankers who think they’re well-dressed are actually walking around naked.

The bottom line: One working paper predicts that Basel III will raise average U.S. lending rates 0.28 percentage point.

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