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Gutting Regulation May Help the Banker, But Harm Society

Do we have to resign ourselves to having a fragile and dangerous banking system, one that harms the economy and requires government support when the risks turn out badly?

As we have seen, there is not much prospect of dealing with failures of large and interconnected banks, particularly those that are active internationally, without imposing large costs on the economy. The economy is also harmed when many banks are distressed at the same time and do not make sufficient loans because of their overhanging debts. It is therefore important to focus on preventing banks and other financial institutions from running into distress or insolvency. For this purpose, we need better regulation and supervision.

In any industry, regulation is important when the individual actions of people and companies can cause significant harm to others. If the banks' own incentives with respect to the risks they take and the extent of their reliance on borrowing were aligned with those of society, banking regulation would be less important. As it turns out, however, the incentives of banks with respect to the risks they take and to their borrowing are perversely conflicted with those of society.

In the last few years, many proposals have been made to address the risks that the banking system imposes on society. Very few, however, have been implemented. Most proposals have been rejected, diluted, or delayed, some of them endlessly it appears, because the banks have convinced policymakers, regulators, and sometimes the courts that the regulations might be too expensive.

What does expensive mean in this context? Who would be incurring the costs of the regulations? From the bankers' perspective, any regulation that constrains their activities or might reduce their profits is expensive. What is expensive for the banks, however, need not be expensive for the economy. The costs to the banks are important, but other costs must be considered as well, particularly the costs to everyone else resulting from financial crises or bank bailouts.

If a producer of chemical dyes is stopped from polluting a river, the costs of producing his dyes might increase. He might then have to charge higher prices, and the prices of dyed products might also rise. Even so, the overall economy might well benefit. If the dye producer's pollution imposes cleanup costs of $20 million each year on downstream cities but the cost to the dye producer of using alternative ways to dispose of his waste is only $2 million per year, there will be an $18 million yearly gain overall if the dye producer is prohibited from polluting the river.

The dye producer will no doubt complain that environmental regulation is expensive because it costs him $2 million a year, but this accounting neglects the $20 million benefit the regulation can bring to others.

When bankers complain that banking regulation is expensive, they typically do not take into account the costs of their harming the rest of the financial system and the overall economy with the risks that they take. Public policy, however, must consider all the costs and not simply those to the bankers. The point of public intervention is precisely to induce banks, or dye producers, to take account of costs they impose on others.

For society, such intervention can be very beneficial. Appropriate banking regulation is available that would reduce the potential for harm to the financial system without imposing any costs on banks other than the loss of subsidies from taxpayers. The simple remedy is to ensure that banks have considerably more equity to absorb their own losses. The fact that this is beneficial and not costly for society is all too often obscured by flawed and misleading claims, what we refer to as the bankers' new clothes. Excessive borrowing increases the fragility of the financial system without providing any benefits to society.

Anat Admati is a Professor of Finance and Economics at the Stanford Graduate School of Business, and Martin Hellwig is a director at the Max Planck Institute for Research on Collective Goods in Bonn. This article is excerpted from their new book"The Bankers' New Clothes: What's Wrong With Banking and What to Do About It." © 2013 by Princeton University Press. Reprinted by permission.



(11) Comments



Comments (11)
U.S. banks today, per the latest FDIC data, hold $1.6 trillion in capital (non-weighted) for the $14.5 trillion in assets that they hold (also non-weighted). That yields an 11% capital ratio, much higher (and much less leverage) than critics claim.
Posted by WayneAbernathy | Monday, March 18 2013 at 12:04PM ET
Of course 3 percent in equity, meaning an authorized leverage of 33 to 1 is ridicule low.

But much worse than the level of equity is that regulators decided the equity required to hold individual assets, should be based on perceived risks of default, the same risks which were already being cleared for by the markets... that is what brought real distortion and caused the banks to overdose on perceived risks.
Posted by Per Kurowski | Monday, March 18 2013 at 10:08AM ET
Dear yerram, I think you caught another false assumption. The "banks" that caused the housing bubble and economic downturn were primarily mortgage brokers and investment banks that created CDOs and MBSs, not the depository banks. Mortgage companies like Countrywide were the main boogymen in that debacle. The depository banks I am familiar with did not betray the public trust in 2007 or any other time. Regardless, the question remains about how much regulation can be imposed before the burden becomes too much. Community banks are saying the burden has grown too large for them to comply. We expect more than 20,000 pages of new regulations as a result of Dodd-Frank. Reg Z has grown from a 45 page pamphlet including staff commentary in the early 80s into a 2,000 page, cross referenced monster, the Volcker Rule has everyone stumped, and Basel III is beyond the comprehension of most of the "bookkeepers" that have run many community banks for years. This trend has to stop if you don't want to drive all the business to a few mega banks.
Posted by gsutton | Tuesday, March 12 2013 at 5:29PM ET
if this were the case, how did banks betray this public trust in 2007? Cost of compliance should always be less than the cost of evasion. Whenever any New Law is created in the same sphere or a new circular instruction is given by the Banks or regulators, it should replace the old Law and not yet another Law and this is the healthy practice of legal formulations. If the law makers ignore this a voice, a strong voice in the public articulation is a must. The capital may not be panacea for all the risks that the banks take. It should not also be too low and also provide high leverage to put the other clients and stakeholders at risk and also for gobbling up huge executive pays and bonuses at will duly endorsed by inconsiderate Boards.
Posted by yerram | Monday, March 11 2013 at 10:33PM ET
This post is surprisingly full of wrong premises. First, bankers don't resist regulation, they resist bad and excessive regulations. I started as a regulator and like the authors initially assumed that bankers would prefer not to be regulated but I quickly found out that was not the case. Public trust is the single most important asset of a banker and being regulated contributes substantially to public trust. The broader point that needs to be made is that new laws and regulations are usually additive. An old law or regulation is rarely repealed when new ones are created. How many regulations can be imposed before the compliance burden becomes counterproductive? Many small banks are claiming now that they can no longer afford the compliance, internal audit and other staff needed to run a modern bank. This is another trend pushing small banks out of the market and more business to large banks. I serve as a director of a large bank and we have substantially increased the audit and compliance staffs to keep up. Small banks cannot easily do that. The authors misunderstand capital as well. A board must constantly balance adequate capital with adequate leverage to attract investors. Banks generally generate low gross profits and must employ leverage to compete with other kinds of businesses for capital. The authors' glib assertion that increasing capital is the only regulatory measure needed is naive in the extreme. It is hard to see these kinds of real world issues when you sit in the legendary ivory tower all day.
Posted by gsutton | Monday, March 11 2013 at 7:59PM ET
One need not entertain any doubt about the value of good regulation and any cost is worth its while as in the finality the community is saved from bearing the cost. In an anxiety to push such costs of high capital to the communities resorting to nationalization of banks or creating public sector banks is a backdoor entry for recapitalization on an ongoing basis by the owner - in such case, the Governments. Governments resort to sovereign debt. Leverage of 33% is not altogether bad as long as such leverage helps the growth of the economy and helps inclusiveness as well.
Posted by yerram | Friday, March 08 2013 at 10:17PM ET
Meekly suggesting we may want to put a few rules in place is not a very effective rhetorical strategy. Polite, but very persuasive. Perhaps a better object lesson may be found on the Las Vegas strip. In the neon bath, we find a truly unregulated "banking" industry. They weigh risk, invest in the infrastructure, and they own their own losses (no federal bailouts for the big boys on the strip). They do have an image problem, but they're working on that too. It's where we're going, so we might want to study their methods while we can. Wall Street is moving there, apparently, or they are moving to Wall Street. Either way, we may all wind up living in North Las Vegas pretty soon.
Posted by teknoscribe | Friday, March 08 2013 at 9:04PM ET
Get rid of the subsidies and the socialization of risk, and the banking industry will restructure itself very quickly into one that does not pose unacceptable systemic risks.

The article is based on two false premises: 1) that government regulation is the only mechanism to manage risk-taking in the finance industry; and 2) that bankers are greedy, irresponsible schemers who will always skate on the edge of disaster if not restrained by politicians and bureaucrats.

It would be helpful if we had more articles written by people with experience as bankers, and not mere ivory-tower college professors.
Posted by Bob Newton | Friday, March 08 2013 at 4:43PM ET
Well, I think you make my case. A careful reading of the column seems to suggest that all regulation is good, and objecting to regulation is bad. And yet you point out that the Basel III regulation has elements to which you object, and well you should. By the way, one of the problems with Basel is that it has such a variety of minimum capital ratios to manage that it becomes difficult to follow, the leverage ratio being just one of them. U.S. banks do not follow just the leverage ratio, by the way. The raw capital condition of U.S. banking industry, that is pure amount of capital compared with pure amount of assets--no risk weightings--is currently ll%, according to FDIC's latest Quarterly Banking Profile, $1.6 trillion in capital, supporting $14.5 trillion in assets, no risk weightings. The 3% ratio you cite is well below where U.S. banks already are.
Posted by WayneAbernathy | Friday, March 08 2013 at 12:09PM ET
To the contrary: it very easy to ascertain "the point of the column" . . . if you actually read it. "The simple remedy is to ensure that banks have considerably more equity to absorb their own losses." Or more simply "Leverage Kills." Basel III's 3% leverage ratio is simply a joke, as it still allows a leverage ratio of 33.
Posted by rebelcole | Friday, March 08 2013 at 11:54AM ET
Hard to discern the point of the column. It may be, as it seems to drift toward the end, a suggestion that bank regulation that adds value is good for banks and bank customers. That is true, and there should be no objection to that. The earlier part of the article, however, seems to suggest that ALL regulation adds value and any objection to regulation is merely an attempt by banks to have permission to be wild and crazy in their practices. That is a much tougher point to demonstrate, and the authors make little effort to demonstrate it. Basel III would be a good example of a regulation that deserves some push back, where careful review of regulation is warranted. The concept that banks should have adequate levels of high quality capital is something on which banker, regulator, investor, and customer can agree. It does not take all of the additional complexity of the standardized approach of Basel III, with its attempt to carve in stone complicated standards for the many moving parts of a living economy, to get there. Neither does Basel III's proposal to make bank capital more volatile by running unrealized gains and losses through capital make for a better or safer banking system. It is important that all regulation add value, and that regulations that do not be changed so that they do. It is not out of line to insist on that outcome.
Posted by WayneAbernathy | Friday, March 08 2013 at 11:46AM ET
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