The Bankers' New Clothes

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.