#318      38 min 13 sec
Banking on the brink: What to do about debt-addicted financial institutions

Stanford economist Prof. Anat Admati talks about how poor regulation and a lack of political will are endangering the global banking system, and why banks remain “addicted” to debt to fund their often highly profitable business. Presented by Eric van Bemmel.

"Banks continue to be plagued by being very interconnected, and very fragile individually and as a system." -- Prof Anat Admati




Prof Anat Admati
Prof Anat Admati

Anat Admati is the George G.C. Parker Professor of Finance and Economics at the Graduate School of Business at Stanford University. She has written extensively on information dissemination in financial markets, trading mechanisms, portfolio management, financial contracting, and, most recently, on corporate governance and banking.

In recent years, Admati has been active in the policy debate on financial regulation. She is the author, with Martin Hellwig, of the book The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It (Princeton University Press, March 2013, see bankersnewclothes.com) as well as research and policy papers and short commentaries. In April 2014, Admati was named one of the 100 most influential people in the world by Time magazine.

Admati received her BS from the Hebrew University in Jerusalem and her MA, MPhil and PhD from Yale University and an honorary doctorate from University of Zurich. She is a fellow of the Econometric Society, the recipient of multiple fellowships and research grants, and a past board member of the American Finance Association. She has served on a number of editorial boards and is currently a member of the FDIC Systemic Resolution Advisory Committee.

Amati visited Melbourne to deliver the David Finch Lecture 2014 for the University of Melbourne’s Faculty of Business and Economics.

Credits

Presenter: Eric van Bemmel
Producers: Kelvin Param, Eric van Bemmel
Audio Engineers: Gavin Nebauer
Voiceover: Nerissa Hannink
Series Creators: Eric van Bemmel and Kelvin Param

View Tags  click a tag to find other episodes associated with it.

Download file Download mp3 (34.9 MB)

VOICEOVER 
This is Up Close, the research talk show from the University of Melbourne, Australia. 

ERIC VAN BEMMEL 
I’m Eric van Bemmel. Thanks for joining us. Our guest on this episode, Stanford economist Anat Admati is a prominent critic of the way banks rely almost exclusively on debt -- and too little on equity -- to provide the funding that enables them to go about their often wildly profitable business. In her book, The Bankers’ New Clothes: What’s Wrong With Banking And What To Do About It, Professor Admati and her co-author, Martin Hellwig, argue that banks globally continue to behave recklessly to distort economies, and to put the public at risk even in this long aftermath to the global financial crisis. 
Just how is it that banks continue to operate at the fragile, over-leveraged edge? How can we create a safer banking system that doesn't sacrifice lending or economic growth? And who and what institutions will take the brave steps required to right what Professor Admati sees as a precarious wrong? 
Her critics have painted her ideas as impractical, economically dangerous and not to be taken seriously. Yet Time Magazine in 2014 included Anat Admati among the 100 most influential people for her strong advocacy of more substantive regulatory change and a wholesale rethink of banks’ reliance on, some would say addiction to, debt.
Anat Admati is George G.C. Parker Professor of Finance and Economics at the Stanford Graduate School of Business. She is in Melbourne to deliver the David Finch Lecture 2014 for the University of Melbourne’s Faculty of Business and Economics.
Anat, welcome to Up Close. 

ANAT ADMATI
Thank you for having me. 

ERIC VAN BEMMEL 
Anat, six to seven years out from the global financial crisis, the GFC, you would claim that we haven’t learned our lesson, that the structural instability, the banking system that enabled the financial destruction that the Americans called “the Great Recession” is still the status quo. What’s plaguing banking systems globally even after the disaster of the GFC?

ANAT ADMATI
Well, they continue to be plagued by being very interconnected and very fragile individually and as a system. And part of the fragility is also the opaqueness of the system. So they are the kind of system that is similar to a house of cards or to a set of dominoes standing right next to one another, just very unstable. I mean that it can't withstand the ups and the downs. It can't function in a downturn. It tends to create booms and busts and instabilities, and the busts are really harmful and hard to recover from. They don’t actually, on their own, recover from them, so they need a bit more guidance to be the stable system that we need. 

ERIC VAN BEMMEL 
They don’t recover on their own; they recover when they are bailed-out by governments. 

ANAT ADMATI
Well, they don’t even recover by being bailed-out because even when they are bailed-out often time, they are just being lent more money by central banks or by governments for that matter, which they then become indebted to also. So nobody alleviates them from the misery of being distressed or but they're plain solvent.  

ERIC VAN BEMMEL 
They’re being lent money, you say. So, this is about debt, this is the central part of your argument?

ANAT ADMATI
Yes. 

ERIC VAN BEMMEL 
Debt, debt, debt. This is what they rely on. That’s their petrol, the gasoline in their tank. 

ANAT ADMATI
Yes, and it is a gasoline of a lot of things. We all tend to become enamoured with credit. We are forgetting that credit is somebody lending to somebody else. There is good credit that allocates resources to businesses and enterprises and even to individuals, but there can be too much of a good thing like that. There could be too much lending, there could be too much lending to government, it could be reckless, wasteful lending. But, we do want steady, good, worthy kind of loans to be made and instead what we get is too much and too little sometimes at the same time because of the disorder in incentives in the system. 

ERIC VAN BEMMEL 
You’re talking about bad loans, but also the fact that banks rely on debt to function. Their working inventory of cash comes from debt?

ANAT ADMATI
That’s right. So they fund their operations way more than anybody and to some extent they are kind of starting with that to the extent that they start with deposit funding by making promises to pay back. They abnormally have very easy creditors, easier than they themselves can be when they lend. If they are prudent lenders, they will be watching out and putting conditions on loans and all of that, but their creditors include, for example, depositors like you and I and we don’t have contracts and we don’t behave like creditors and watch out for the banks. We delegate that to regulators and that’s exactly where the issues start. 

ERIC VAN BEMMEL 
Psychologically we don’t consider ourselves creditors, we’re just depositing our money. 

ANAT ADMATI
Exactly. People forget, so anytime I talk about this, I was shocked how much I need to remind people that we actually lend that money to the bank and we want them to use it because we want them to make loans, but when they do that, they take risks with deposit money and who then bears the downside of that? It becomes the question. If we just give our money to the banker and the banker can lend it and then if it doesn’t work out, we have to bail the banker out. That’s not such a great system for us because while the loans are paying and while the investments work out, the banker pocket is all the upside. That’s a pretty distorted system there and for that system, going to Las Vegas would also seem attractive to the banker. 

ERIC VAN BEMMEL 
If we look at corporations that are not financial, typically they rely on 60 per cent to 70 per cent equity or earnings. Google, you’ve mentioned in your writing, 94 per cent. So very little debt there. 

ANAT ADMATI
Around that. It really depends how you do the accounting. In all these things sometimes for the high tech companies, you’re not going to see the sort of book value, the accounting value really matching with their market value. There're all these issues about who puts numbers on evaluations of assets. Depending on that, if you count by market value of equity, then certainly the banks are by far by a really shocking amount more indebted than any other corporations and some of that is natural to banking because deposit taking is natural to banking. But at some point, it just becomes the way they like to fund. Not that they have to, they just want to. That doesn’t make it good. It’s just that it’s their incentive to do it that way. 

ERIC VAN BEMMEL 
Just a few factoids from my reading of your work. Banks are typically about 5 per cent equity financed these days. That’s after some new regulations that have strengthened those requirements. It used to be 2, 3 per cent. You’ve mentioned the eight largest US banks derived little less than 5 per cent of their funding from shareholders in 2013. The remainder is borrowed, yet these banks are growing in size. Even if we look at before the GFC and after, they’ve actually grown. We think “too big to fail”, but this is "too bigger to fail". 

ANAT ADMATI
On these numbers, you’re going to start debating the numbers, they’ll give you risk-weighted ratios and they’ll look better and is it 5 per cent or 7 per cent, are they recognising the losses on the asset evaluation?  The numbers always have a can of worms of putting values on things which is always controversial about what the loan is worth or whether it is a nonperforming loan or performing loan or it’s like a mortgage or whatever it is and when do you recognise losses. All of that and then how do you do the derivative accounting, all of those are incredible cans of worms in term of what these ratios really mean. The regulatory ratios count away, just ignore some exposure, so there are a lot of exposures that are netted out and off the balance sheets and all of that. 
So that’s why these numbers, they are still kind of in the single digits when you look at equity, meaning assets minus liability; what is left over if you were to somehow liquidate it like your home equity in the house if you sold it and paid off your mortgage, that kind of thing. That, in the single digit number, is relative to the total assets and those numbers are just not healthy for any corporation. We don’t regulate other corporations, how much they borrow and how much they fund with equity and yet the market is giving them signals that it’s really unhealthy. We have a lot of academic writing about this, that it is inefficient. We know this, we teach this for corporations to have a lot of debt, it introduces inefficiencies in their investments; it increases the wasteful costs of the fault and distress, disruptions. 
All of those bankruptcy costs are taken into account by investors usually but in banks they are not. Nobody directly involved cares enough about that because there are people outside that balance sheet, the taxpayers, the governments, the deposit insurance and somebody else who incurs all these costs.  

ERIC VAN BEMMEL 
If we look at nonfinancial companies, borrowing is regulated…

ANAT ADMATI
By the market. 

ERIC VAN BEMMEL 
By the market. By lenders, right?

ANAT ADMATI
By the lenders and so that is how the markets function without regulating the funding mix of how corporations do. But in banks, once we have insured deposits, already there is a conflict. From that point on, the banker is going to want to live more dangerously than it would be good for depositors, so who is protecting those people? They don’t have really good contract s that they want to really go after that’s why they delegate it to regulators. It becomes really critical to correct what banks want to and can do at that point unless they are prevented from it. 

ERIC VAN BEMMEL 
Anat, we’re not talking only the United States here. It’s a global story.

ANAT ADMATI
Yes. The system has become incredibly interconnected, so nowadays whatever happens anywhere affects an entire global system. This has been beneficial, some would say, but it brought a lot of instabilities and it actually exacerbated the "too big to fail" problem because it’s very difficult, almost impossible and we have not made progress on the failure of a global financial institution. We don’t have a mechanism for that. When they fail, they fail locally. They splinter into thousands of little pieces and subsidiaries according to different laws of different countries and it’s a mess. And they can meanwhile move the money like Lehman did just before it went bankrupt, in different countries. All of a sudden there was money in the US and no money in London. And those problems, there were some attempts to deal with them a little bit, but fundamentally we don’t have a process for a sort of global bankruptcy and who shares the losses and how it plays out. Nations start fighting over who bears the losses. 

ERIC VAN BEMMEL 
You were referring to the failure of Lehman Brothers, the investment bank. 

ANAT ADMATI
That’s right. 

ERIC VAN BEMMEL 
In 2000…

ANAT ADMATI
In 2008, September 15, so exactly six years ago. Almost to the day. 

ERIC VAN BEMMEL 
Historically, has it always been this way? There were times when banks had more equity, right? They were safer in that sense. How long ago was that? 

ANAT ADMATI
Well, the history of banks include all kinds of changes in the way they operated in the scope of their operations. When people say to me banks have always been fragile, my answer is that they have never been completely efficient as corporations and we can discuss this in length, but what’s changed is the scalability of the risks and the global nature. The size that you mentioned and we can talk about how scary those sizes are that they have gotten to and how uncontrollable those sizes are and can really continue to grow unless we really contain it. What’s been an example is 19th century private banks in UK. There were private partnerships with partners whose entire own assets were on the line, so unlimited liability partners who had to pay depositors if the bank couldn’t. 
So they weren’t corporations, there weren’t limited liability corporations and 50 per cent of the investment of the banks were funded by the shareholders’ money, by the owners money and only 50 per cent from deposits. And that’s how you had to be safe because there was no deposits insurance and no central bank and depositors wanted the banks’ owners to be liable and so you had a banking crisis in Glasgow at the end of the 19th century and it was the shareholders that went broke, not the depositors. The depositors got paid from the shareholders own assets. Of course you couldn’t have very big banks because nobody would put their money and delegate it to a manager who might steal it because then they’ll have a governance problem of controlling the managers. 
When banks needed to grow somehow and governments wanted banks to grow and they were allowed to become limited liability corporations, which really only happened after the Great Depression in the US when they established deposit insurance because before that some banks still had double, triple and unlimited liability for their equity. Even through the depression, owners of the banks could be asked to pay more. Here we are today where the bank managers can use both shareholders and creditors and depositors’ money to do all kinds of things. Book profits, get a bonus and never actually be accountable for both the risks they take whether it was good risk or not and meanwhile it worked for them. I mean not even talking about illegal things, but even the legal things that can be done where nobody is accountable and the recklessness works for those who make those decisions. 

ERIC VAN BEMMEL 
I’m Eric van Bemmel, on Up Close. This episode, we’re speaking with Stanford finance professor, Anat Admati about the precariously over-leveraged state of banking systems globally and why the banks seem to like it that way. Up Close comes to you from the University of Melbourne, Australia. 
Anat, looking at regulatory and legislative responses to the GFC and banking instability in general, there are things that are country specific. You had in the United States the Dodd-Frank Wall Street Reform and Consumer Protection Act, usually known as Dodd-Frank in the US. In 2010, you had what are called the Vickers rules in the United Kingdom. These are very complex ways of trying to address the problems. And you have also these international accords, like most commonly the Basel accords, up now to Basel III. Can you give us a bit of an idea what they are and do they succeed? 

ANAT ADMATI
Well, Basel is an international agreement that is meant to be a minimum standard agreed upon by 27 nations and then it’s their choice whether and how to implement it, whether to go beyond it. This Basel III follows Basel II which, I think it’s safe to say, spectacularly failed. I think the countries that implemented Basel II most enthusiastically were the ones that did the worst. In the US it was the investment banks that were regulated according to Basel III and not the depositing institutions and they were the ones that failed the most, Lehman Brothers and Bear Sterns in particular. Europe has shown incredible vulnerability that it’s still suffering from partly because of the flawed Basel II as a regulatory framework, inadequate and badly designed regulation. 
Basel III meant to correct the mistakes except that it ended up really tweaking Basel II. It’s the way to describe it. It continued to use the flawed framework of pseudoscience of risk calibration that has only led the banks to game the regulation and to concentrate their risks where the regulation thinks for political and other reasons that there is safety like in lending to governments in Europe or something is rated at Triple-A safe until it’s not, et cetera, et cetera. And so it has not changed that much. 
Now going beyond it, what you have is a sort of a race to the bottom sometimes where the banks go to say oh, you are being tougher than the other guy or you need to worry about my competitiveness with another country which is something we don’t accept for other ways that a company can risk citizens. We do not accept that a company would pollute a river in order to compete with a company that’s allowed to pollute a river. 
Some other country, DoddFrank Act in the US, just one sentence on that, tried to give regulators ever more authority to do more things. The problem with Dodd-Frank is some of it is too much, some of it is too little and mostly the implementation is a complete mess. The regulators can do more, but then they don’t for a number of reasons that would take a little while to discuss, but some political reasons. 

ERIC VAN BEMMEL 
But part of both Dodd-Frank and Basel III, in some small way, have required banks to increase their capital standards, thus reducing the reliance on borrowed money. But you are saying that was not nearly enough. You were recommending something around 30 per cent of holdings should be equity-based. 

ANAT ADMATI
Not holdings, but the funding. Yes, we are saying that the numbers that are being discussed are unnecessarily allowing dangerous skirting near the edge and are not doing enough to prevent. It is akin to having too high speed limit basically, but here there isn’t really a cost to the economy to having stable banks. You could redirect some assets in the economy to be owned by the banks and backed by equity and we, as investors, are investing in everything in the economy, so there is no new changes; where we are shuffling pieces of paper to just say banks should have less debt that is not essential banking. Deposits may be essential to banking, but other debt is not essential to banking. 
Even if some of their debt is useful, they can add equity to it, and even if they buy assets that are otherwise held by other people by assets funded with equity, this way they are not getting into distress and default and there is no need to go through bail-ins and all kinds of complicated procedures with triggers because they are automatically just functioning. You don’t have to sell assets in fire sales. Everything just gets stabilised. They can make the loans, they can withstand the upside and the downside, no link too much and too little, lend at appropriate prices, just correct distortion. 
In all the arguments that I have heard against this, actually I have heard no coherent answer to why not. Now, it’s not like I have a macro model that captures everything because some things I am talking about are really complicated, governance problems and inefficiencies in investments that are hard to quantify. Instead, we have models that actually miss big elephants in the room and then they give you answers that are just wrong. So you can choose your data and you can choose your assumptions and your analysis can be all flawed. And everything that has been done is not based on sound analysis, by my consideration. I have read a lot of it. 

ERIC VAN BEMMEL 
But you are recommending that some 30 per cent of funding should be equity-based. Where does that number come from?

ANAT ADMATI
Well, we actually don’t mean that number literally. We mean as a kind of just to say a lot more because when they say a lot more, they say, oh, it’s such and such present more than before. On this my favourite quote is the one from Martin Wolf right when Basel III came out which is tripling the previous requirement sounds tough until you realise that tripling almost nothing doesn’t give you very much. They don’t say, oh, instead of 98 per cent, it is now 94 per cent, they say, oh, we tripled the 2 per cent to 6 per cent or something. That sounds like a lot percentage wise, but you started from almost nothing, so percentage wise all these spins about how it’s so tough are just wrong. Really what we mean to say is just a whole order of magnitude more like add digit kind of thing. 
It depends what the risk is. It depends what the bank is. If you have an investment bank that can scale up risks through derivatives that we don’t see and it doesn’t have deposits, then it should have 50 per cent equity. If it’s a commercial, small, mutual funded, only does loans and then takes into account risks and it can do some diversification of the credit risk although it is still exposed to some market risks and interest rate risks, maybe 10 per cent is enough or 8 per cent. It does depend. If you had a structural reform where you had different institutions doing different things, I would tailor it to the risk, definitely tailor it to the risk but in a more crude way, not in these fine tune pseudoscientific way that they do it right now where they splinter the balance sheet into millions of little pieces and have weights on them. 

ERIC VAN BEMMEL 
How would banks now go from say 5 per cent equity to say 30 per cent? How would they do that?

ANAT ADMATI
They have a source of equity that all corporations use all the time in the transition and that’s the way to transition without giving them ratios to which they might respond by cutting new lending that we really need. Give them more money and more incentives to make the loans that we need them to make. If they say I won't make the loan until you guaranteed or something that they will do as a favour making the loan. I want them to want to make the loan. I want to reduce the conflict between what they want and what we need which is usually the way we want the invisible hand to work. If you are to say to them just that, raise a particular amount of equity depending on the bank. Retain you profits if you have them. That money can be invested on behalf of the shareholders. 

ERIC VAN BEMMEL 
Stop dividends. 

ANAT ADMATI
For a while, just for a while because the money is still there. Most of the companies that we’re talking about, Google, Warren Buffett, most of the companies, the first source of funding is their profits. They invest the profits on behalf of their shareholders and the shareholders are happy if they make good investments for them and the shareholders realise that these investments were made on their behalf. And if the stock is traded in the market, they can sell some stock if they need some share because market price will reflect that good investments that are made. 

ERIC VAN BEMMEL 
If anyone will buy them. Some nonviable banks, so called zombie banks -- who is going to buy those shares?

ANAT ADMATI
Exactly, but we don’t want the zombie banks. The zombie banks are harmful for the economy. Zombie banks, dysfunctional banks, are just being reckless and not helping. You can have a lot of zombie banks which we forbore and allowed to persist during the savings and loan crisis in Japan in the last decade and then right now in Europe. And this kicking the can down the road is not helpful. This keeping alive those zombies, nursing them back to life, no. Now we need nonviable banks to be unwound not in a crisis because in a crisis we got to worry about the functionality of the system, the disruption of the systems. Now is the time to clean it up, basically. That’s what we’re saying. 

ERIC VAN BEMMEL 
You’ve also written that there are other things we can do besides increasing capital standards to improve banking. We can “fail the banks” better, reduce their too-big size, and also perhaps go back to the study of separating out activities?

ANAT ADMATI
Yes. Working on resolution is important. Reducing the size, my hope, will happen more naturally because conglomerates that became very big and the banks by the way now are bigger than any company in the world. They are really the biggest corporations by far of all corporations. All the biggest ones in the world, they are all financial institutions. 

ERIC VAN BEMMEL 
Bigger than Apple?

ANAT ADMATI
Oh, oh. By far, by far, by far. Ten times bigger than Walmart. These are enormous corporations, trillions of dollars’ worth. If you included derivative exposures, even a lot more depending on how you do that kind of accounting because you can have a lot of risks, but very little seen as assets and liabilities. In any case, if they are inefficient, oftentimes investors push for them to break up and become more nimble and more efficient. So corporations can break up off their own inefficient weight, but that does not happen because they keep having access to that funding that’s cheap when they are implicitly guaranteed. That is why you don’t get efficient size. I want the size to be determined by markets ideally. And so once you bring the funding cost in the right investors, don’t worry about the downside into the mix more, then the markets will start giving them signals about the efficient size as well as about efficient investments and other things. In other words, the downside and the upside will be more together. 
So, yes, it’s hard to do the structural of separations. Those are harder to do. What I’m proposing is the no-brainer part of it, it’s the easy part of it. You still have governance problems about accountability and risk controls in these banks, but I want shareholders to be more motivated to care about the risks because right now some of the risk is born by creditors and tax payers and that’s not healthy. So yes, opacity of the system is still large. Derivative trading is still too opaque, we don’t see it and you can see in episodes like "London Whale" how little we see really what’s going on down the ground and even the management of the companies and the regulators, how much they really know. So there is a lot more to be done there, credit rating agencies, all kinds of flawed incentives within the system that are not giving us the best system we can have. 

ERIC VAN BEMMEL 
But strengthening equity requirements is low hanging fruit. But it’s fruit that’s yet to be picked. It’s still sitting there in the tree.

ANAT ADMATI
Exactly. 

ERIC VAN BEMMEL 
This is Up Close coming to you from the University of Melbourne, Australia. I’m Eric van Bemmel. In this episode we’re speaking with finance and banking researcher, Professor Anat Admati about how to address what she believes to be a global banking system that remains very much at risk. 
Anat, there are a number of people who are pushing back on your ideas of strengthening capital requirements. They have a number of objections. Do you mind if I just throw a few at you and see how you want to field them. 

ANAT ADMATI
Go for it. 

ERIC VAN BEMMEL 
Stanley Fischer, currently Vice Chair of the US Federal Reserve System, former governor of the Bank of Israel, and former World Bank Chief Economist, he agrees in principle with what you’re saying, but he believes the US is, as he says, “constrained by practicality”. 

ANAT ADMATI
I’m not exactly sure what he had in mind about practicality because I can tell you that practically there is nothing really to stop the regulators in the US. 

ERIC VAN BEMMEL 
I think he sort of meant if the US takes that advice, goes it alone, they’re actually putting themselves out of the market. You can take your money somewhere else, to some other country. 

ANAT ADMATI
Well, the things that you control and the things that you don’t control. Somebody wrote me an email saying, if the US implements what you want, it was just when I think Sheila Bair mentioned our commendations before even the book, I will move my money to BNP Paribas, bank in France. To which, my response - and I didn’t hear back from that person - was first I really hope your money is diversified across a lot of things and not just invested in US banks because they might actually be able to use less subsidies by my proposal and I think those subsides are really distorted and delivered in the wrong way. I really think they should be reduced, I didn’t elaborate. Number two, if you move your money to BNP Paribas, what I have to say about that is that I feel sorry for the French tax payers because what this is telling me is that the French are letting their banks be reckless and mostly the French will suffer from that in the end. 
So, the way it is right now, we still have national governments and taxpayers in particular jurisdictions having to step in if they choose to and save their own banks. When these banks get very big and global and reckless, that can be harmful. You can look at Ireland and Iceland for examples of that and other countries have had very large banking system that they needed to save including in the UK as well Netherlands. 

ERIC VAN BEMMEL 
Cyprus. 

ANAT ADMATI
Well, Cyprus for sure and Netherlands, UK and Switzerland. It can be quite costly for taxpayers to have successful banking system. And so the question is, how do you protect your jurisdiction, your people best? And in Europe it’s complicated because European treaty allows banks to go across borders and open branches and things like that. Still, there are certain things that they can do but they need more collaboration which is why they started discussing seriously banking union in Europe.  In the US, foreign banks have come to US land and US can control what happens on its soil. If somebody invests money in a French bank, they depend on the French government to save them. This is what happened when UK depositors deposited in Icelandic banks and the UK government is still haggling over it with Iceland while Iceland is refusing to pay the Dutch and the UK depositors and there you have that. 
Practicality in this, I don’t see what the problem is. I see that international collaboration is a good thing except if it leads to this race to the bottom. Instead, the US can lead the world in bank safety and I don’t see any legal problem for that. I know the US laws and they allow the Fed to do anything it chooses. Of course it has to run stress tests or satisfy certain requirements but I can talk to you about the stress test or about these living wills and I can tell you, it’s a big charade; it’s what they all are. The answer to the question, what will happen in a certain scenario is the following: we don’t know exactly. That’s the answer, the true answer, if they were honest with what they know and don’t know because they do not see the interconnectedness in the system, the contagion mechanisms, all those things. 
Instead of pretending to know and pertaining to the models or giving you answers that were safe enough, the other big insight is what is what’s the cost of being safe? In the financial system, there is actually no social cost. This safety we get almost for nothing, for reshuffling pieces of paper in the economy. That’s it. 

ERIC VAN BEMMEL 
What about money moving to more informal sectors of finance? The so-called shadow banking economy. If you could just, first of all, define what that means and is there a risk that strengthening capital requirements in the formal banking system means money is going to be leaking out?

ANAT ADMATI
What we have in every regulation and every law is an enforcement problem. We always have that. The shadow banking system that we have, what people call shadow banking system has a very misleading term. This system is a result of ineffective enforcement of previous regulation and the ways to get around the regulation with risks importantly building up in plain view of regulators. 

ERIC VAN BEMMEL 
But what does a shadow bank look like?

ANAT ADMATI
A shadow bank is a money market fund. Is that in the shadows? It’s in front of our eyes. This is, in the US, a 2.7 trillion industry in broad daylight that needs better regulation. 

ERIC VAN BEMMEL 
It’s not as regulated as the banking system typically?

ANAT ADMATI
It’s not as regulated even though it competes with the banking and it actually is a bank. It promises a dollar but it doesn’t want to pay deposit insurance. If it quacks like a bank and acts like a bank, why is it allowed to be called a mutual fund?

ERIC VAN BEMMEL 
And yet during the GFC, the global financial crisis, the Federal Reserve created a commercial paper funding facility to provide liquidity backstops. In other words, a bailout in a sense or to at least guarantee or take on the risk of these shadow banks, correct? That’s now been wound up. 

ANAT ADMATI
Definitely. A lot of institutions. Here is what happens in the shadow banking. Shadow banking was a way for the banks to fool the regulators oftentimes. They would create an entity and they would give the special purpose vehicle or whatever they called it, a backstop themselves. If they give it backstop and we give the bank a backstop, then we’re giving a backstop to the shadow bank. Implicitly at least and we saw it come to be being explicit, we are supporting the system to the extent that it is linked directly to the institutions that we govern. So the shadow bank is a hedge fund for example. 
Hedge funds are less regulated in other banks, but in the financial crisis actually head funds failed in the dozens making no sound and no systemic impact. The only hedge fund that has become systemic over the many years is long-term capital management. That was 1998. We know that we have to watch for risks building up, but when they build up they’re pretty visible. It’s not in some shadowy alley. In the book we gave the example of saying, just as a parallel argument, that we shouldn’t outlaw robbery because the robbers are going to some dark alleys. Well, you give the police man a flashlight, you’re not going to say the police is only walking on these lighted streets and if the robbers go to the dark alleys, then too bad then we just have to live with robberies. No. You want to enforce robbery laws and you want to enforce financial regulation and you need to shine the light on where the risk is going. Most of the most dangerous risk is going straight out of the regulated industries into entities in the shadows. 
The shadow banking is a misnomer and it just is a name for the enforcement problem that we must face anyway. The notion that because we have been ineffective in regulating the system, we should give up on regulation, we have to bear the consequences if we follow that logic. That is a very flawed logic. 

ERIC VAN BEMMEL 
Are the bankers being overly discredited for the behaviour when in fact it’s the policy makers and academics that are failing us?

ANAT ADMATI
Oh, certainly the academics and policy makers are failing us. And the politicians. They have created a set of narratives that hide their own failure to effectively regulate this system. All the bankers are doing is responding to the incentives in front of them and so if you get into their heads, you will see precisely why they’re doing what they’re doing. Often it is legal or it’s the best they can do under the competition. If you have a system in which the speed limit is a 100 and the driver can get saved out of the imploding vehicle, the insurance is subsidised and he gets a bonus when he gets to the destination. Of course they will speed. That’s their incentive. The problem is, why don’t you set a speed limit and enforce a speed limit and measure the speed correctly and all of those things that has to do with law enforcement, and with creating laws and rules of the road. 
Instead what you have is an ideology against regulation where in fact the markets are failing and everyone who hates regulation should hate the fact that we’re hostage to a system that if it fails, it will create even more harm than if we bail them out. It filters back to reckless behaviour, lawless behaviour sometimes and then to prosecutors who say it’s too big to jail and then now you’re going to have to think about systemic impact of prosecuting this bank or these people or you don't have evidence that they did something wrong and there is no accountability throughout this. 
And the banks are very, very political. Governments often want the banks to lend to them and oftentimes therefore they harm business lending, the public gets confused about what’s going on, threats are being thrown around. Just a lot of politics, so I blame entirely and I address entirely the policy makers and all the people who spin narratives about how whatever we see must be good because it’s free market and we can't interfere with markets and all of that. When in fact what you see is a big failure of market and a big inefficiency that must be handled through effective regulation.

ERIC VAN BEMMEL 
Anat, just finally and very quickly, what can the consumer -- the simple depositor -- do?

ANAT ADMATI
A depositor who is insured should go about their business being a productive member of society. 

ERIC VAN BEMMEL 
Not worry about it?

ANAT ADMATI
Well, you want to be prudent. Part of the financial system that are also distorted potentially is mis-selling and imposing risk on people and excessive fees and all that. I definitely say, buyers beware. Remember that not everybody who tells you to do something tells it to you for your fiduciary, oftentimes they do not have your own interest in mind. It’s not just in financial industry where you could have fraud on reselling or something, so buyers beware especially about risk which people don’t always understand. In terms of these policies of financial stability, just realise a lot of banking emperors are naked. This is the title of our book, The Bankers’ New Clothes. We don’t just mean bankers, we mean the banking emperors. Everybody that somehow is making excuses for the system that we have and justifies this system based on flawed arguments, so don’t believe what you’re told. Sometimes they’re not telling you the right thing. Tell the policy makers you want a stable banking system. 
But, in any case, what individuals can do is not worry about the small amount of deposits because most countries will stand behind that and pretty quickly repay you. This notion of standing by the ATMs like what happened in Cyprus is sort of unlikely. Certainly about larger amounts of money, you should worry because eventually somebody has to bear it and they might impose it even on depositors above a certain amount. And so you just have to spread the money around, diversify and be worried about paying excessive fees. Be worried about the small print of any kind of money situation where you delegate to somebody else because oftentimes there are the rude awakenings that can happen from the small print. 

ERIC VAN BEMMEL 
Anat Admati, thank you very much for being on Up Close. 

ANAT ADMATI
Thank you for having me. 

ERIC VAN BEMMEL 
We have been speaking with Anat Admati, George G.C. Parker Professor of Finance and Economics at the Stanford Graduate School of Business. She is co-author with Martin Hellwig of the 2013 book, The Bankers’ New Clothes: What’s Wrong With Banking and What to do About It.
For a full transcript of this episode and more information on our guest, head to the Up Close website. Up Close is a production of the University of Melbourne, Australia. This episode was recorded on 17 September, 2014 and produced by Kelvin Param and me, Eric van Bemmel. Audio Engineering by Gavin Nebauer. Up Close is created by me and Kelvin Param. 
Thanks for joining us. Until next time. Goodbye. 

VOICEOVER
You've been listening to Up Close. We're also on Twitter and Facebook. For more information, visit upclose.unimelb.edu.au. Copyright 2014 the University of Melbourne.


show transcript | print transcript | download pdf