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Review of “The Bankers’ New Clothes”

Anyone who knew anything about banking watched the lead up to the 2008 credit crisis with great trepidation. Anything financially “innovative” was in and prudency was out. The regulators had decided that a spreadsheet was all that was necessary to keep the world safe from financial danger.

What’s Wrong with Banking and What to Do about It” is the jacket summary on Anat Admati and Martin Hellwig’s excellent explanation of exactly what went wrong in the banking industry. They live up to their own hype, which is something for a couple of academic policy wonks. As they explain in some detail, the banking industry has used “It’s Complicated” as a successful strategy to bilk the economy of what a professor would call “excess economic rents” or what a banker would call a huge and glorious bonus pool. They use the device of “Kate’s House” to explain the concept of financial leverage and why bankers go to extraordinary lengths to run with as much debt as possible. Once Admati and Hellwig demonstrate this, they go on to explain why this is a one sided bet: “Heads, my bonus increases and Tails, we get a costly bailout from society at no personal cost to me!”

Running with the highest possible level of debt is shown to be the logical strategy for a modern bank. The authors explain that this necessitates “regulatory capture” with lots of lobbying dollars and campaign contributions sent the way of anyone who can help in piling on the debt. The authors are outraged by the lack of regulatory change after the Credit Crisis, considering the huge cost to society. They even point out that increasing the size and complexity of a bank’s quest for “Too Big to Fail” status will ensure the maximum state support of its financial imprudence. Since solvent banks were encouraged to bail out their insolvent peers in the Credit Crisis, Admati and Hellwig think the problems are now worse. They argue the solution is a much higher level of equity, in the range of 20 to 30%. While this might sound reasonable, the tightening up of Basel 3 regulations demands a mere three per cent of common equity with 97 per cent debt financing. They point out that previous attempts to regulate by assessing the riskiness of assets were doomed to failure and the current regulatory thrust will be defeated by the selective “risk models” of shrewd and self-serving bankers.

There have been many “Tell All” books on the recent financial crisis with lurid accounts of the self-serving greed of banks and bankers. This book explains the principles of leverage and banking in very simple and understandable terms. A great book for the financial neophyte or expert that should be required reading for every central banker, regulator and politician involved in banking regulation.

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