The Banker's New Clothes

The Banker’s New Clothes does something kind of incredible. It manages to explain banking in plain English, with examples that anyone can understand. While the Great Recession seems likes something that can be explained rather easily, the aftereffects and actions we must take to prevent the next meltdown might not seem so people friendly. Even better Admati and Hellwig are able to cut through the financial jargon and rhetoric in order to show people why Wall Street isn’t working, and why we aren’t taking the necessary steps to fix it. The Banker’s New Clothes starts with a quote from former French President Nicolas Sarkozy criticizing banks for taking the risks that led to the financial meltdown. If Sarkozy felt so strongly about this, one could infer that France then took the incentive to crack down on banks and their risky lending behaviors. Admati and Hellwig are quick to point out their hypocrisy; because French banks have been a major focus of concern in the European crisis since of they have very little equity and a lot of short-term funding. This was one of the reasons why Dexia, a French-Belgian bank, had to be bailed out twice in 4 years; their equity was less than 2% of their assets after the first bailout which was depleted after September 2011, and was then unable to deal with the Greek Crisis in October leading to the second bailout.  Admati and Hellwig become very critical of these situations because they know that it could’ve been prevented. Banks continue to argue that any regulation is “expensive” and would diminish their growth. Admati and Hellwig see this a bugbear saying, ““When bankers complain that banking regulation is expensive, they typically do not take into account the costs of their harming the rest of the financial system and the overall economy with the risks that they take. Public policy, however, must consider all the costs and not simply those to the bankers” Admati and Hellwig see this and the new “regulations” as the apt named Bankers New Clothes, which stems from the story The Emperor’s New Clothes. This is what Admati and Hellwig say has been happening in the banking world, the new so-called regulations are leaving banking naked, but no one is courageous enough to say anything. Admati and Hellwig propose to break up big banks, because they reach a point where they’re unmanageable and inefficient since they’re more subject to governance and control problems. Retail banking in Germany, deposits and small-business lending, is dominated by banks that are active only locally, in particular savings banks in public ownership so they weren’t hit as hard during the crisis. It was only the public banks that suffered and became a liability in the economy.

Part of the reason this book is so successful is because it takes banking examples and uses the example of a woman named Kate to explain them. For example, if Kate buys a $300,000 house and her down payment or initial equity is $30,000, a subsequent drop of 10 percent or more in the value of the house will wipe out her entire equity and leave her underwater. By contrast, if Kate invests $60,000 as a down payment, she will lose her entire equity only if the price declines in value by 20 percent or more; otherwise she will continue to have equity in the house. A bank usually only has about 5% equity so any drop in the value of assets really endangers the bank’s solvency.  What bankers don’t like about capital regulation, though, is that it’s “expensive” the manner I quoted before. These liquid assets don’t acquire interest, so the banks see it as a loss, but in reality it would incentivize investment because the risk that would usually be on the creditors and taxpayers would now be on the bank. This book’s views might be seen as rather controversial, especially to bankers, but I think that their controversy will lead to a more open discussion on compromise that will incentivize people to learn more about the economy and stop their fear of confronting Wall Street.