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.

  • Alain Sherter On Twitter»

    Alain Sherter is an award-winning business journalist who has written for The Deal, MarketWatch and Thomson Financial Media.

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