The Bankers' New Clothes
The case for far higher bank equity capital.
Summary
Admati and Hellwig argue that banks should be required to fund themselves with far more equity, and that every argument the banking industry makes against this is either wrong or self-serving. Their proposed level is twenty to thirty percent of total assets, which is several times what regulation requires.
Their central analytical point is that equity is not something a bank holds in reserve, it is a way of funding assets, and the phrase capital requirements misleads people into thinking money is being set aside idle. From this they attack the industry's arguments in sequence. The claim that equity is expensive confuses the observed cost of equity with its cost at a different leverage level, since Modigliani and Miller establish that reducing leverage reduces the required return on equity. The claim that higher equity requirements reduce lending confuses funding mix with balance sheet size. The claim that banks are special because deposits are their product does not follow, since the argument concerns how the rest of the balance sheet is funded.
They argue the real reason banks resist is that debt funding is subsidised through explicit and implicit guarantees and through interest deductibility, so leverage transfers value from taxpayers to bank shareholders and managers.
The book is written for a general audience and is unusually clear. Its argument has been influential and remains contested by banks and by some economists, principally on whether the Modigliani-Miller adjustment is complete in practice and on whether activity would migrate to less regulated intermediaries.
Key takeaways 7
- Bank equity is a way of funding assets rather than money set aside, and the term capital requirements misleads almost everyone who uses it.
- The claim that equity funding is expensive confuses the observed cost of equity at high leverage with its cost at low leverage, which would be substantially lower.
- Higher equity requirements do not reduce lending, because the requirement concerns the funding mix rather than the size of the balance sheet.
- Banks prefer debt because it is subsidised through deposit insurance, implicit guarantees and interest deductibility, which transfers value from taxpayers.
- Risk-weighted capital measures are manipulable through model choice, which is why a simple leverage ratio against total assets is the more reliable constraint.
- Bank equity of twenty to thirty percent of assets would make failures far less likely and would not impose meaningful social cost.
- Bank executives' compensation is tied to return on equity, which gives them a direct personal incentive to maximise leverage regardless of the risk created.
Who should read it
Investors, policy readers and bank directors who want the clearest statement of the case for much higher bank equity funding.
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