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Why banks are still unsafe

(MoneyWatch) As the new year began, the mood changed. It felt as though everyone had decided: We've had enough of crisis. It's over. Let's get back to business. Call it crisis fatigue, if you want: Consumers wanted to feel good enough to go shopping and bankers wanted them to too. And because the market is prey to animal spirits, it went up and, around the world, you could hear a collective sigh of relief.

Willful blindness was working its magic again, as Stanford's Anat Admati spelled out in gruesome detail at the Danish Institute for International Studies:

  • The banking system is still fragile, over-leveraged and too dependent on short-term debt and deposits
  • The banks are still highly connected and woefully prone to copying each other
  • The over-the-counter derivatives market remains dark and fundamentally unregulated
  • Off-balance sheet vehicles (once called SPVs, now called VIEs) make it impossible to see what's really going on. (SeeFrank Partnoy's forensic analysis of Wells Fargo, ostensibly one of the more conservative banks)
  • We have fewer banks that are bigger, not smaller ones that we can allow to fail
  • Banks are still not lending in meaningful amounts to real businesses; they still mostly lend to one another, thus concentrating risk
  • Bankers are under more pressure than ever to deliver alpha

Dr. Admati, author of "The Bankers' New Clothes," compares the banks to chronically sick people who maintain unhealthy lifestyles -- say the heart attack victim who won't give up smoking. Resuscitating these people feels essential but just because they're alive doesn't mean they're healthy. The issue was, is and remains changing their bad habits.

Her solution is to reduce the debt to which the banks have become addicted. If they sell more equity, risk is shifted from innocent taxpayers and society to investors -- with the additional benefit that stock prices go up, investors absorb the upside and the risk and society need not bear the costs of strategic mistakes.

"Well designed capital regulation that requires much more equity will increase the stability of banks. At the same time, it would enhance their ability to provide good loans to the rest of the economy and remove significant distortions. This may reduce the growth of banks but will have a positive effect for everyone else," Admati stated.

All of this makes sense, not just to you and me but to the likes of [Bank of England Governor] Mervyn King and Nobel economics laureate Kenneth Arrow. I have some questions about who will be willing to buy the equity stakes on which this plan depends but if bankers believe in their business model, they will. Admati is surely right that the balance of risk must be shifted from the public -- which never agreed to under-write banks -- to investors who may choose to. They get the upside, they take the risk. Isn't that the way we used to do business?

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