Bank Regulation: Admati and Hellwig's Home-Run Rethink

The Bankers' New Clothes

While Thomas Piketty's book has been getting great public attention, being compared with Keynes's General Theory, the March 2014 Journal of Economic Literature includes a a review by Roger B. Myerson of the University of Chicago that points to another as of equivalent importance.

It should not be surprising that the Great Recession would call forth two such heralded books appearing within months of each other. Like the Great Depression, the crisis of 2007-2008 and its aftermath was a big, complex event requiring corresponding intellectual effort to understand and interpret.

Myerson argues that Anat Admati and Martin Hellwig have successfully made such an effort, considering why bank regulation failed. They have come up with a book that will be important and lasting. The book, The Bankers' New Clothes (Princeton and Oxford: Princeton University Press, 2013), makes some surprising arguments.

One surprise is that they recommend that no provision be made for the riskiness of assets in the Adequacy of Bank Capital (ABC) requirements. This has been a cornerstone of U.S. bank examinations and the Basel equity capital standards. American bank examiners for decades have categorized each bank's loan portfolio based on risk, and risky loans are charged against equity capital. When I worked for the FDIC as a financial economist, 20% of "substandard" loans were charged against capital, 50% of "doubtful" loans and 100% of loans were categorized as "loss".

The authors argue for two main changes in bank regulation:

• Equity-capital adequacy should be set at 20-30 percent of total assets. This gives a substantial cushion against losses and means equity holders have a higher stake in the bank.
• Banks should not be allowed to pay any dividends to stockholders if their equity is below 20 percent.

This proposal has the powerful merit of simplicity. The Dodd-Frank legislation attempted to patch back up the easily understood system created in 1933 with the Glass-Steagall legislation. Dodd-Frank has become mired in procedure as many of the provisions in the lengthy patch-up required further action by the various regulatory agencies. Bank lobbyists have been ready at every step to minimize the impact of regulatory action.

Myerson explains well why Admati and Hellwig are on the right track. I agree with him and them. The Glass-Steagall Act's simplicity contributed to its swift passage and long life. In fact the Steagall part, relating to the FDIC, is still in place. The banks in 1933 wanted deposit insurance. Carter Glass's wall between banks and investment banks was the price that the banks paid for putting the Treasury at risk for deposit insurance. But the banking industry ended up at the turn of the century taking the deposit-insurance cheese while dismantling, over nearly seven decades, the Glass half of Glass-Steagall.

It may be difficult now - to change the metaphor - getting the stray chickens back in the banking coop and the speculative foxes out. But the Admati-Hellwig solution of 20-30 percent equity capital requirements for banks offers this possibility. Myerson's review ends:

Economics professors can't do it alone. Political leadership is also needed to get the public's attention and communicate the new principles by which the public should judge its financial institutions, regulators, and politicians.

Amen.