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.