The purpose of this book is to demystify financial language. Bankers use many misleading terminologies and claims which confuse everyone including politicians and regulators. Admati and Hellwig explain what finance is, does, and the fallacies created by misuse of language. Using a parable of The Emperor’s New Clothes, pointing out the misleading claims and language of bankers in order to take appropriate actions. This book does a wonderful job at elucidating the claims of bankers to understand policy discussions and evaluate the claims.

Banks contribute to making smooth economic exchanges via payment system infrastructure. Borrowing is an essential feature of a well and efficient functioning economy. Banks are more experienced in investigating the ability of others to pay loans than others. When functioning appropriately, borrowing creates opportunities to make large investments which would otherwise not be able to financed. But borrowing also magnifies the borrower’s risk. When the economy is booming the investment earns more than the debt servicing, but the risk of investment default magnifies the cost of debt servicing. By not taking account of the potential loss of investment, banks can easy claim that borrowing is cheaper than equity. Equity reduces the potential gain and loss from an investment as the shareholders carry the risks. When banks did not have guaranteed bailouts, they used to have large amounts of equity to attract borrowers.

A misleading term in banking is capital. Banks claim capital requirement will limit the ability of the banks to lend money, but capital requirements are not reserve requirement. Capital requirements refer to equity in the bank. Equity is a source of funding for lending, not a restriction. With more equity in the bank, the owners of the bank will have to pay the price should the bank fail. Banks considers equity expensive because they will have be forced to pay for the their mismanagement of risk rather than their lenders or taxpayers. Bankers benefit from the fragility of the financial system, but it imposes costs on everyone else. Unlike the claim of bankers that safety would hurt everyone, making banks safer would create stability without reducing lending or hurting the economy.

Banks normally function based on maturity transformation. Making long duration loans of high interest rates while borrowing short duration loans of low interest rates. Most bank assets are long term which are not readily transformed into payments, which causes liquidity problems. This problem is normally surmountable, while the problem of not having enough assets to pay loans posses economy wide problems.

The close to certain guaranteed government bailout of financial industry creates perverse incentives within the industry. The income generated by risky loans stays with those who made the loans, while the costs of default derived from those loans is borne by taxpayers. As bankers keep their prior earnings from the defaulted loans, there is an incentive to produce loans no matter their quality as they will not carry the costs of problems. The bailout guarantee also reduces the interest rate cost of bank borrowing, as their lenders know that they will regain their money should the bank default. The lowered interest rate acts as a subsidy to the financial industry and prevents policies which would make banks safer. The guarantee subsidies the creation of a more risky and dangerous financial industry.

Bank regulation changes how banks behave, to either more risky practices or safer practices. Even before repeal of Glass-Steagall, banks have been defaulting due to many problems. Some decades saw very little bank defaults due to the performance of the rather than quality banking practices. Banks have always been risky, but also tried to better position that risk. Securitization which was supposed to facilitate safe practices, ended up transferring risk to others while creating more risk. Risk does not disappear, rather, it is a matter of by whom the risk is borne on default.

Part of the reason for bailing out banks lies with contagion. If a bank owes debts to other institutions and goes bankrupt, it may cause the other institutions to go bankrupt as well. The interconnectedness of the financial system can spark global economic problems. Authorities are concerned about large institutions going bankrupt, but not so much small institutions creating a need to grow big to gain a guarantee from the government.

This book’s main solution is to have banks have more equity as it would reduce the risk that the banks cannot pay their debts and reduce their risk taking to protect that equity. The problem with this is who owes the equity. As the authors point out, corporations tend to fund themselves with equity and debt, while banks tend to only use debt. Corporate equity shows that the employees, such as the CEO, do not always have the best incentives for the company as any damages would be borne by shareholders and not the CEO. Meaning, the officers of the bank would not by necessity change their risk behavior if the equity is not owned by the officers of the bank. Equity is seen as a panacea to all bank woes, but it can create perverse incentives as well.

This book is an eloquent description of banking structure. The focus tends to be on potential defaults, but that is because they are usually ignored in favor of more optimistic default-less future. Admati and Hellwig do a wonderful job at showing ways that debt creates risk and alternatives to debt. Making opaque the confusions created by bankers. Exposing many arguments as misleading and fallacious. Banks provide a fundamental service to all economies, but they also pose risks to those economies. The incentives given to bankers should not be perversely in favor of creating costs to societies they serve as current policies do. What is needed is to limit the risks posed without limiting the benefits they provide, which can be done with equity.
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A good introduction to how modern banking works, and the author makes a powerful case for requiring banks to hold more equity. She also dispels many of the myths bankers try to sell the public and politicians (hence the "new clothes"). Even though it provides a primer on banking, it did get over my head at times, and was very repetitive in the second half of the book - constantly referring to the first half. Overall, good though. ( )

Hellwig, Martin F. (Author.)

A very clear exposition that builds from very basic economic/finance first principles to an increasingly complex analysis of financial regulation, clearly defines one side of the debate over financial regulation. ( )

In short:

- The Bankers' New Clothes is a useful book in that it makes clearly the case for higher equity requirements for banks. This does seem a much more sensible path than separating ill-defined activities.

- The book does however fail to account for the difference between US and EU financial systems. As a consequence, significant costs of higher equity requirements are overlooked. The criticism of risk-weighted assets is unconvincing.

As a result, I do recommend writing this. But I also recommend to keep in mind that the author are less knowledgeable about the inner functions of the banking system and less clear-eyed than they think they are. For an European, the US centrism and EU-bashing gets irritating after a while.

Full review: http://bs-initiative.org/index.php/documents-de-travail/item/130-reaction-to-%E2... ( )