Big banks are as risky as ever, economist warns

(MoneyWatch) Anat Admati can foresee the country's economic ruin -- or its salvation. However the chips fall, she'll be able to say "I told you so."

In an important new book due out next month, "The Bankers' New Clothes," the Stanford University economist warns that the U.S. banking system is as precarious today as it was before the 2008 housing crash. And given the vulnerability of the country's biggest banks, it won't take the kind of gale-force financial winds that blew down the global economy roughly four years ago to trigger another collapse.

"Even without a crisis, it's a system that is living on the edge," Admati said in an interview.

The result: Banks often lend too much, leading to periods of wild speculation, or too little, as lenders pass up worthy loans because they can make larger profits on riskier activities. In both cases the economy suffers. Banking is "too highly indebted, and it leaves people subject to all kinds of ups and downs and booms and bust," she added. "There are indications that the financial system is becoming bigger and bigger and more knotted up in the sense of interconnectedness."

Admati warns that one explosion could topple the entire system.

If it does, the catalyst is almost certain to be the same ingredient that brought down the financial system -- debt. Big banks are "addicted" to it, said Admati, who notes that no other corporations come close to borrowing as much money as lenders do. Immediately before the financial crisis, many large banks had debts amounting to 97 percent of their total assets. To this day, banks rely almost entirely on debt to fund their business, commonly having less than 10 percent in equity, and often as little as 5 percent. 

Princeton/Rich Feldman

That shift happened over many decades. Paradoxically, it also occurred in part because of government efforts to protect banks from losses, such as with the expansion of deposit insurance in the 1930s.

"From putting in a safety net in order to have a safer system, we ended up enabling more borrowing," Admati said. "As a result, equity levels declined almost continuously from 25 percent down to the single digits over the 20th century. And then, in the last 20 or 30 years, banks have found clever ways to borrow through derivatives markets and other innovations. That allowed more borrowing and also more hiding of leverage."

Debt-laden banks have little margin for error. When financial conditions sour and their assets lose value, they can get into trouble in a hurry. Indeed, this debt "overhang" can destabilize lenders even before a downturn hits. That's because borrowing amps up a bank's financial gains -- including executive bonuses -- while losses are shared by creditors. Given this misalignment in incentives, borrowing begets borrowing.

"We have to fight back against this addiction to debt," Admati said. "It's as if someone is driving too fast -- we have to slow them down. There's too much collateral damage."

Admati, who co-authored the book with economist Martin Hellwig of the University of Bonn in Germany, is no ordinary Cassandra. For one, she's among the country's most important financial economists. In the years since the subprime meltdown, Admati, 56, also has emerged as one the most respected and pointed critics of Wall Street, using commonsense arguments -- sharpened by her economic expertise and copious empirical research -- to debunk bankers' claims that the financial system is safe.

Second, she's not merely a critic, but rather comes bearing solutions -- solutions she says would help banks perform their essential function of funneling money into the broader economy while also defusing the risks ticking away within the financial system. 

One such approach is to limit banks' exposure to their financial partners. That would reduce the danger of a single bank "counterparty" falling into trouble and causing a shock wave to ripple throughout the entire industry, as AIG's insolvency did in 2008. But even that would only make for a smaller crater, not deter banks from taking risks in the first place.

In Europe, meanwhile, regulatory authorities have proposed walling up banks' retail lending, deposit-taking and other government-backed businesses to insulate them from their far riskier investment banking activities, like trading. Yet that approach also has glaring weaknesses.

Admati's preferred fix is for big banks to use much more equity to fund their assets and investments and much less debt. After all, just as homeowners are less likely to get foreclosed the more equity they have in their houses, so banks are more likely to remain solvent the more equity they have in their business. Enhancing a financial institution's ability to absorb losses by requiring them to hold more equity also reassures a lender's depositors and creditors, guarding against the kind of crippling bank runs that paralyzed the financial system in September 2008.

Beyond such practical remedies, Admati offers non-financial experts and other laypeople a framework for evaluating the arguments that bankers make when they feel threatened by new rules -- that they are too complicated to be regulated like other businesses. "There is a pervasive myth that banks and banking are special and different from all other companies and industries in the economy," Admati writes. "Anyone who questions the mystique and the claims that are made is at risk of being declared incompetent to participate in the discussion."

This narrative pushed by the financial industry over the years -- a set of ill-founded claims that go unchallenged by most politicos, regulators and financial experts -- gives the book its title and guiding metaphor. Strip it away and Wall Street, the emperor of finance, stands exposed.

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[robintoledo]

The banks already took me down. Unemployed since November 2008, 401K destroyed, living in a town that is full of poverty, had to sell everything I owned...the list goes on. The best way to punish the bank and Wall St. thieves is to take all their money away. Jail would be too good for them.

[superdem1]

The banks have their hooks into our politicians, so we can't get any meaningful regulations passed. They want to be able to make shady deals, with no one looking at their books. That is the capitalist system some people are so in love with. The same people willing to elect a President who won't show you his tax returns. Scary.

[hypnotoad72]

"corporatist system". Big banks helped create a massive mess and it's the little people, trapped in the middle, having to pay for it all.

But the system will crash again. Anybody paying attention knows that supply-side bailouts at the expense of the demand-side, in return for the supply-side trashing the demand-side, can only lead to a crash.

Those who cash in before everyone else will appreciate it the most.

It's the system where people are told either in microprint or outright "Don't afford to invest what you can't afford to lose" and yet people put their retirement money there, will politicians want to move social security into it.

Are people really so dim they can't see what's obvious?

[venusvegasvada]

Remove the Gramm-Leach-Bliley Act

Reinstate the Glass-Steagall Act.

Remove the Federal authorization for bucket shop, side betting legalization from the 2000 Commodities Futures Exchange Act.

The half-@ss band aid fixes they try to apply to the system will not work. The underlying problem is the banks are too big and too interconnected.
The old way was the way to go. Stable. Manageable.

What do you want? High risk/profit or lower profit/stability? You can't have it both ways.

The real answer is the changes made in 1999 and 2000 was an utter failure. Time to end the experiment and reset everything back to prior to 1999. The problem is the Govt. lacks the nut sack to be able to do what has to be done. Christ, they can't even pass a budget (which is basically their main job). They haven't done that for something like 4 or 5 YEARS now. It's getting to the point where someday, there won't be anyone left in Congress that even REMEMBERS the last time anyone passed a budget. These are the same buffoons that caused and allowed this problem on Wall Street to happen, then screwed up the repair of it.

I hate to say it but this ladies comments will fall on deaf ears and nothing will get done. It's a matter of pain. Obama managed to save and salvage the system and like the lady said, they are on life support and are being shielded from the realities of their failure. Until the bottom REALLY falls out and crashes, nobody "gets it".

[hypnotoad72]

http://occupycorporatism.com/obama-omits-disclosure-on-his-two-bank-accounts-at-jpmorgan/

Assuming that article and source are accurate, of course. Take it with a grain of salt, of course...

[stamicrach]

SAVE YOURSELF NOW.!!

Put all your money in and borrow money from local smaller banks.

Big banks basically have no worries if they go bust, because they know our blood-sucking government will bail them out with more money (that we don't have) from already suffering taxpayers.

Eliminating the Federal Reserve is also another way to solve a lot of the US financial crises.!

[nicht01]

This is becoming old news. If banks had no debt, there would be minimal risk. If corporate america had no debt on its books, there would be minimal risk. So the issue is where does one draw his/her line in the sand for an "appropriate" risk level?

Regardless of capitalization structures of lending institutions, banks need to make a profit which is predominantly composed of its 1) net interest margin and 2) other categories (fee income, etc).

The higher the regulatory burden and capital structure, the higher the customer interest rate and/or fee structure needs to be to create an adequate shareholder return. There is no free lunch in a capitalist society.

Financial leverage is a two-edged sword. So Ms. Admati's argument can be placed with all the other pundits as to the answer of the question, "What is the proper level of capitalization to prevent the next systemic meltdown?" It used to be 3% of tier-1 capital. Now it's targeted at 10%.

I submit the answer to the banks is not depth of capital. Rather, bank risk should be looked at in terms of how the risk is diversified. For example, if I'm the bank and I have just one customer, and that customer fails...then my bank fails. If I have 100 customers and one customer fails, then my risk capital and my bank survives. None of the pundits/economists/analysts seem to examine risk diversification when evaluating bank strengths. Yet they (the economists) sure do get their names lit up and published.

When giving press, CBS/Alan Sherter needs to drill deeper. Get the whole story...like CBS used to.

[realitycheck212]

Your answer bears some merit at face value, but there is a problem. The Wall Street banks should already have been diversified, before the market crash of 08. The trouble is, there are crooks in the system, ie those that bundled the bad loans into risky investments, then got the ratings agencies to give them 5 star ratings (more crooks). So, diversification should have been followed before 08, but it was corrupt behavior that caused the real problem.

Imagine if I was 'selling' you a product, but in doing so I made it so incredibly complex that you really couldn't grasp all the implications of it. Wouldn't your 'something sounds fishy' warning bells be going off ? The crooks on Wall Street have done just that, with derivatives.

The truth is, we need much more reform than even Dodd-Frank provides.

Interesting how the crooks don't want to be regulated, but that is what is needed.