Poor Kate. The value of her house sinks, and she defaults on her mortgage. It happens again. And again. Her business fails a few times, too. But Kate makes the best of her bad luck; she borrows other peoples’ money and tries not to put too much of her own at risk. She borrows cheaply, too, thanks to her rich aunt Claire.
Poor Kate is spoiled, rationally selfish, and carelessly destructive. She also doesn’t exist. Anat Admati and Martin Hellwig invented her for the pages of The Bankers’ New Clothes, not to preach about the importance of personal responsibility but to serve as a stand-in for a banker. The authors frequently return to Kate’s plight throughout the book. And they frequently mention two bankers in particular: Jamie Dimon, the chief executive of JPMorgan Chase (JPM), and Bob Diamond, the former CEO of Barclay’s. The portrait does not flatter.Courtesy Princeton University Press
It’s no secret that the banking system has some powerful critics. Two national movements—the Tea Party and Occupy Wall Street—flourished in part out of frustration with Wall Street’s privileges, and its failures. Last year Sheila Bair, former head of the Federal Deposit Insurance Corporation, and Neil Barofsky, special inspector general for the Troubled Asset Relief Program, both published their memoirs, laying out the preventable damage large banks got away with over the past decade. Last June, Richard Fisher, president of the Dallas Fed, pointed out that large banks, even sound ones, enjoy a subsidy from being seen as too big to fail. (A month later, Bloomberg Businessweek featured research that valued that subsidy at $120 billion from 2007 to 2010.) But all these criticisms lack coherence, a unifying story. Bankers are greedy, and they bend the state to their will. Well, yes, but we’ve known this since the Medicis of Florence.
But Admati and Hellwig have done something extraordinary. They took this frustration and all its complex details and gave it a simple narrative, one that both explains what banks have been getting away with and what we might ask that Congress do about it. It’s easy to grasp, potent, and memorable: Banks usually ask us to hold 20 percent equity when we borrow. We should ask the same of them.
Back to Kate. She buys a house and takes out a loan for part of it. Her equity is the amount she contributes from her own pocket toward the purchase. Then the house begins to drop in value. The greater her equity, the more loss she can absorb before her home is worth less than the loan she took out. But Kate doesn’t want a lot of equity. She’s hoping the house will become more valuable. If it does, what she borrowed remains the same and what she owns increases. So the less equity she starts with, the greater the percentage of her profit. Less equity: great on the upside, catastrophic on the way down. Mortgage lenders and homeowners learned this lesson, together, during the housing crash.
The Bankers’ New Clothes lays this out with grade-school math and reveals how investment banking is no different than owning a home. What we call equity in our own homes, bankers call capital. This is what a bank’s shareholders contribute to its investments before borrowing money to cover the rest. Just as with Kate, less capital means a better upside for the bank’s shareholders (and for its officers, whose bonuses encourage them to increase returns on shareholder equity). And again, as with Kate, it leaves less to absorb losses before a bank defaults on its loans.
Yet the most recent round of international negotiations on bank capital require banks to hold only 3 percent. Imagine walking into a bank and asking for a mortgage with 3 percent down. This is what the banks are asking of us. Admati and Hellwig propose a regulation that would land like a cow patty in a Senate finance committee hearing: Banks being required to hold 20 percent to 30 percent capital.
Banks argue that capital—equity—is expensive. Shareholders demand a higher return than lenders. The authors point out that this is true but inadequate. Lenders offer money cheaply to banks because governments, no matter what they say they’ll do, always end up backing loans when large banks fail. Where Kate has her overindulgent aunt Claire, the banks have Uncle Sam, keeping borrowing costs low with what markets still see as an implicit guarantee.
Bankers love jargon, and they love complicated regulations. Democracies are easy to confuse, and complexity is easy to spread with lawyers and chutzpah. The Bankers’ New Clothes, though, poses a simple question: If Kate should hold more equity, why shouldn’t Jamie?