Book review | The bankers’ new clothes

In a new, expanded version of her book The bankers’ new clothes, Anat Admati And Martin Hellwig demystify banking and reveal how current financial regulatory practices enrich bankers while increasing the risk of economic crises and undermining democracy. Admatis and Hellwig’s call for reforms to increase stability, particularly through higher capital requirements for banks, is more urgent and compelling than ever, writes Hans G. Despain.

Anat Admati spoke about the new edition at a public LSE event in May. Watch the event again on YouTube.

Bankers’ New Clothes: What’s Wrong in Banking and What to Do About It (New and Expanded Edition). Anat Admati and Martin Hellwig. Princeton University Press. 2024.

There is a certain magic about banking and high finance. Too often, it is believed that these industries are too difficult and complex for ordinary mortals to understand, and so, the argument goes, regulation should be left to financial experts.

In her book Bankers’ new clothes: What’s going wrong in banking and what can be done about itThe aim of Anat Admati and Martin Hellwig is to demystify banking and high finance in a language that the general public can understand. They argue that this hegemonic Orwellian attitude of “leave it to the experts” enriches the bankers but endangers society by causing financial crises and economic recessions and poses a fundamental threat to the rule of law and democracy itself.

The new edition is actually three books in one. First, there is their original argumentative section, published in 2013 in thirteen chapters and 228 pages. Second, there is their expanded and updated section with four new chapters and 123 pages. Third, there are their 173-page endnotes. In their original and expanded editions, Admati and Hellwig brilliantly make the details of banking and finance accessible to a wide audience. Their endnotes offer more esoteric insights and quotes for experts.

It is disturbing that the original argument from 2013 is still relevant and timely. Unfortunately, it is even more urgent.

It is worrying that the original argument from 2013 is still relevant and timely. Unfortunately, it is even more urgent. The main message of the book is that banks should be required to hold more capital.

Admati and Hellwig point out that nonfinancial firms typically invest with 20 percent or much more of equity. If they did not have at least 20 percent of equity, banks would consider a nonfinancial firm to be too risky a borrower (105-7). Historically, financial firms hold 25 percent or more of equity. If the value of the financial firm’s investments declines, the losses would be borne by the financial firm’s shareholders/owners. In this case, investment losses would have no negative impact on the bank’s ability to repay its depositors or on the financial firm’s ability to repay its creditors as long as the investment losses do not exceed the financial firm’s equity.

Admati and Hellwig highlight the fact that the capital employed by financial firms has declined dramatically over the past sixty years. Today, the capital requirement for financial firms is at a dangerously low three percent, and due to legal loopholes in accounting, financial firms can reduce it even further (85-7 & 251-8).

The US and global financial systems are too fragile, mainly because there are no adequate capital requirements.

They argue that the US and global financial systems are too fragile primarily because of the lack of adequate capital requirements (6-8). The lack of adequate capital requirements (20-30 percent) is due to the fact that the financial industry is both under-regulated and misregulated (233-8). The under- and misregulation is due to “regulatory capture” (203-7; 327-334) and a misunderstanding of how financial systems work.

According to Admati and Hellwig, the fallacious understanding is either ignorance (ixxvi), deliberate obtuseness (314, 508n9), or willful blindness (248, 253). Bad theories and arguments protect the financial industry from appropriate regulation. In Hans Christian Andersen’s fairy tale The Emperor’s New Clothes, the new clothes are a fallacy: the emperor is naked. Likewise, without appropriate regulation, the banks are naked.

A lot of The new clothing of bankers aims to debunk false claims made by the financial industry and its supporters. However, this debunking has not stopped bankers, lobbyists, politicians, academics and others from continuing to make these false claims and inventing new ones.

Faulty claims still dominate the financial policy debate. The insidious thing about them is that many of their supporters don’t care whether they are true.

Faulty claims still dominate the financial policy debate. The insidious thing about them is that many of their supporters do not care whether they are true, but use them strategically to gain the loyalty of policymakers and the general public and to win legislative debates on banking regulation.

Admati and Hellwig have produced a document titled “The Bankers’ New Clothes Parade Continues: 44 Erroneous Claims Debunked” that summarizes the erroneous claims made by bankers and their supporters, which they continually edit and update.

The claims help to expose the under- and misregulation of the industry. The erroneous claims, in turn, expose the public to unnecessary risks, financial instability, and economic crises (145-7). The financial system does not support the mainstream economy as well as it should (148-66, 231-67) and distorts the economic actions of participants (142-5), leading to massive moral hazards, problems (122-7), and perverse incentives (324-30).

This fragility becomes particularly dangerous because, on the one hand, the global financial system is closely interconnected (60-78) and, on the other hand, finance is closely linked to industry and society (208-28). The fragility arises from the fact that the banking system is inevitably dependent on short-term deposits and short-term debt as liabilities and generates its income through long-term loans and investments.

In addition, inadequate regulation allows financial institutions to be highly leveraged, meaning banks invest not with their own money but with other people’s borrowed money (208-28). The reason a bank or anyone else would invest with high leverage is because it magnifies the return on investment. But remember that leverage also magnifies losses.

The high level of systemic leverage in the financial system means that the profits and losses of individual banks are enormous. The interconnectedness of banks means that the huge losses of a few banks can have a contagious effect (60-65). Like apples in a barrel, one bad bank can affect all the other banks in the system.

Although banks are larger and more powerful today than they were in 2013, they are “still too heavily indebted, and many of them are too big, too complex and too opaque” (237). Therefore, the system is still too fragile, vulnerable to systemic crises and thus dangerous for society.

In 2010, Obama promised, “No more bailouts. Period.” Yet bailouts continued as usual. There are countless examples of central bank support and bailouts of financial institutions over the past seventy years.

In 2010, Obama promised, “No more bailouts. Period.” (272). Yet bailouts continued as usual. There are countless examples of central banks supporting and bailing out financial institutions over the past seven decades. The most extensive was the S&L crisis of the 1980s, which cost taxpayers $124 billion, according to the Federal Reserve Bank of Dallas. Even larger bailouts occurred during the major financial crises of 2007-2009 (283). The 2007-2009 debacle cost U.S. taxpayers $700 billion to bail out struggling banks and other companies, and according to several sources, over $20 trillion in cash injections were required during the crisis to keep the financial system from becoming contagious.

In anticipation of the 2023 banking crisis, the federal government made the extraordinary decision to insure all deposits, including those that exceeded federal insurance limits. This measure rightly drew widespread criticism, prompting Admati and Hellwig to ask, “When will they finally learn?” Bankers and depositors who knowingly took risks were bailed out because there were “too many to fail.”

Admati and Hellwig fear that the bailouts will continue “forever” (291-312). They further warn that the financial, economic and political hegemony of the bankers threatens the survival of the rule of law (313-47) and represents “a fundamental threat to our democracies” (351).

Admati and Hellwig warn that, given the banks’ monopoly position, democracy itself is at stake.

Admati and Hellwig warn that democracy itself is at stake, given the extent to which banks exercise their monopoly power. The monopoly power of banks is inevitably a consequence of faulty logic and of narratives that “have no more substance than the Emperor’s New Clothes in Andersen’s fairy tales. To avoid the dangers (to our democracies), we must ensure that public discourse gives more power to truth” (351).

With both editions of The bankers’ new clothesAdmati and Hellwig have made an enormous contribution to financial research and to society as a whole by highlighting the dangers of bad policies that destabilize banks and tell ordinary citizens are too complicated to understand.