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Speaking Truth to Bankers

The House Financial Services Committee momentarily wondered whether to put Jamie Dimon, the financial demigod whose responsibility includes running J.P. Morgan Chase & Co., under oath when he appeared in June 2012 to explain how a trader known as the London Whale lost a few billion dollars. The committee’s chairman at the time, Rep. Spencer Bachus, an Alabama Republican, made the idea of sworn testimony disappear faster than a triple-A rating on a mortgage-backed security.

Connoisseurs of banking and financial crises may think a sworn oath is their best chance of getting credible explanations from bankers who consider honesty akin to a synthetic derivative. It’s based on something, and that’s as much as they’re willing to say in public.

“The jargon of bankers and banking experts is deliberately impenetrable,” write Anat Admati and Martin Hellwig in “The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About It,” their contribution to the rich literature of bad banking and its consequences. “This impenetrability helps them confuse policymakers and the public, and it muddles the debate.”

Admati and Hellwig don’t just criticize bankers. The real strength of their book is that they walk their readers through the balance sheet and to a regulatory answer to the banking problem, an answer that’s elegant in its simplicity and far-reaching in its potential to prevent and manage financial crises. They say banks should be required to have more equity on the balance sheet. Much, much, much more equity. The authors propose 20 percent to 30 percent of total assets.

At a stroke, they would put much risk back in the private sector, the place everybody says it belongs and where few believe it is. “At such levels of equity, most banks would usually be able to cope on their own and require no more than occasional liquidity support,” Admati and Hellwig write.

Most companies manage equity levels at or above 20 percent to 30 percent of assets. Their creditors probably insist on it. Even bank balance sheets once had equity worth about 50 percent of assets. Equity means somebody else absorbs losses before the lenders take the hit, or, in the case of banks, before the government bails them out. Apple Inc., a company that has received much recognition for its success, stumbles along with no debt at all, a point Admati and Hellwig point out with relish.

Modern bankers manage a balance sheet nirvana denied to ordinary corporate mortals. The banks are like homeowners during the housing bubble. They borrow to the hilt.

As Admati and Hellwig show, using a simple mortgage to illustrate, the bankers have figured out that using somebody else’s money to pay for almost all their assets gives them a nice profit when asset prices go up and gives somebody else — often taxpayers — a painful loss when they go down.

The reason for this unfairness is the bankers’ confidence that when the crisis comes, the government will save them. They’re building their businesses on that confidence.

Bank lobbyists are undoubtedly contacting members of Congress and regulators to make sure Admati, who teaches at Stanford’s Graduate School of Business, and Hellwig, director of the Max Planck Institute for Research on Collective Goods in Bonn, Germany, don’t get a foothold with their heretical idea that banks should behave like other companies.

“The Bankers’ New Clothes” says a thick cushion of equity would go far to resolve many risks that bankers and regulators spectacularly failed to manage before the financial crisis. The equity providers, the bank’s shareholders, will supervise the management more closely because they can’t count on a government bailout to save their investment. Closer supervision should bring more transparency earlier about what the bank managers are doing. The lonely voices calling for the banks to be broken up may find that stiffer equity standards will create a caste of investors willing to sell bank assets at any sign they aren’t being well-managed.

The bank lobbyists who take the case to Congress and the regulatory agencies will plead that equity costs too much and that the requirement will push up the cost of borrowing for the businesses and consumers who drive the economy. But Admati and Hellwig see the argument as another example of bankers misleading the public by encouraging it to overlook the obvious. Their book’s title comes from the Hans Christian Andersen fairy tale in which only a small child is willing to point out the obvious: that the emperor has no clothes.

Banks pay more for equity than debt today because debt is subsidized by the implicit guarantee of a government bailout and by explicitly favorable tax treatment of interest, they say. Equity also costs more because banks are reckless and investors demand a greater return to compensate for that risk. When bankers take fewer risks, shareholders will accept lower returns. The cost of equity will go down, the thinking goes.

Admati and Hellwig also want the equity ratio calculated against total assets, not the risk-weighted ones that are themselves a form of financial perversity: “The weights are determined by a mixture of politics, tradition, genuine and make-believe science, and the banks’ self-interest.” Greek government debt was as risk-free as German government debt even after the Greeks defaulted, they write.

The difference between J.P. Morgan’s total assets and its risk-weighted ones is about a trillion dollars. The logic of risk- weighting is that some assets — Greek government bonds or triple-A rated mortgage securities, anyone? — have less risk than others. The practice of risk-weighting is that risk is identified when it’s too late.

Returning to J.P. Morgan, Admati and Hellwig’s 20 percent to 30 percent proposal would require the company to hold about $450 billion to almost $700 billion in equity against its $2.3 trillion in assets, more than two to almost four times the current level of equity.

That may seem excessive for a bank seen as one of the best run in the United States. Yet, when the London Whale surfaced in spring 2012, Dimon first dismissed it as a “tempest in a teapot,” then estimated its losses around $2 billion, and eventually worked his way up to $6 billion. Bankers were “sloppy,” “stupid” and used “bad judgment,” he said.

The gap between a tempest and $6 billion at one of America’s better-run banks may be enough to persuade even the most trusting soul to ask whether these are questions that should not be left to the bankers.

“The public has a much greater interest in the banks’ safety than the banks themselves,” Admati and Hellwig write.

Randolph Walerius is an analyst for the CQ Roll Call Washington Securities Briefing.

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