Teaching and research distractions have again kept me from blogging for a while. I guess my defense is that learning the facts is always an important precursor to writing about them. This morning, however, I decided to divert from class preparation to add my praise for what is surely destined to be the BOOK OF THE YEAR on financial regulation and its reform, by Anat Admati and Martin Hellwig and entitled The Banker’s New Clothes: What’s Wrong with Banking and What to Do About It (Princeton Un. Press 2013).
Admati and Hellwig are leading figures in the financial reform debate, both in the United States and Europe. Anat Admati has blazed the trail in exposing the muddled nonsense so many bankers talk when they debate whether higher capital levels would make our financial systems safer. We see examples of this confusion every day: for example as recently as yesterday Bloomberg News ran a report in which a senior consultant was quoted as blaming lower loan-to-deposit ratios in part on “new regulations” that “include holding more capital to cushion losses.” Ironically, on the same day the Wall Street Journal ran a report on the “flood” of business loans “roaring back” into the market. Obviously something other than capital is making the difference between lower lending rates in some areas and higher lending in others (low borrower demand in certain sectors?; some loans being more risky than others?; no more NINJA and liar loans allowed?; and so on). The Bankers’ New Clothes explains the fundamentals of bank finance once again to illustrate why the Modigliani-Miller theorem (which says that absent other costs it would make no market difference whether a firm uses capital or debt to fund its operations) remains relevant, though insufficient, for understanding the dynamics of finance in banking.
There are of course some countervailing considerations, for example whether there are tax advantages to using debt rather than capital, and whether the public subsidies that support banking are among the reasons why banks choose to use “other people’s money” rather than their shareholders’ capital. These are complex and difficult issues, but they are rigorously anticipated and investigated by Admati and Hellwig. By contrast, the counterarguments, which raise important points, remain surprisingly (after all this time and debate) tentative, seldom directly addressing studies published both in the United States and Europe, by Andy Haldane (and his research staff at the Bank of England), Reserve Bank research staff in the United States, Simon Johnson and James Kwak and many more experts and commentators.
The sweep of The Banker’s New Clothes is much broader than just the debate about whether banks should be required to hold more capital. The reality of bank lending and bank politics is explored in detail and woven into the analysis at many points in the book. The authors develop much more fully their previously published talks and research papers.
This is the kind of serious analysis and discussion we badly need in order to achieve effective reforms. It will be well worth investing the time to read The Bankers New Clothes.