U.S. banking industry needs more effective regulatory reform

Stanford finance Professor Anat Admati says requiring financial institutions to use significantly more equity funding can yield big benefits to society. Otherwise, the financial system remains inefficient and at risk for another costly economic meltdown.

Excessive indebtedness in banking endangers and distorts the economy, according to a Stanford professor who urges more effective regulation of the banking industry.

“The current and proposed regulations are complex but on some of the most important pieces, they only tweak previous regulations that failed to provide financial stability,” wrote Anat Admati, a professor of finance, in a forthcoming paper in the Journal of Legal Studies. Admati, who has written extensively on this topic, is part of a larger effort to study banking regulations.

The problem, as she sees it, is that bank investments are overwhelming financed with debt, including consumer deposits, and they rely on very little equity, or money, from owners and shareholders.

The economic collapse of 2007-09 highlighted just how fragile the banking system has become, she noted. Unfortunately – and ominously – not much has changed in the way of stronger banking regulation.

“This fragility is greatly exacerbated by the fact that banks use extremely little equity,” wrote Admati, the George G. C. Parker Professor of Finance and Economics at Stanford Graduate School of Business.

Even with higher equity levels, she said, banks could offer all their socially valuable functions, including lending, taking deposits and issuing other money-like securities. Requiring the banking industry to use more equity would stabilize the financial system and reduce the harm of inefficient boom-and-bust cycles and the likelihood of financial crises, Admati said.

‘Too big to fail’

While she argues that there is a strong and compelling case for much higher equity levels given what we know about the economic forces, she acknowledges it is difficult to determine the “best” requirements in the absence of appropriate models and data.

“The details and the numbers are really tricky to state, because equity ratios depend enormously on how assets are evaluated, what is included and not included in the denominator, and lots of other details,” she said.

But Admati believes the current regulations are entirely in the wrong range and have no valid justification whatsoever: “They are based on very flawed analyses of the relevant tradeoffs.”

She is also concerned with the breakdown of governance and control, as evidenced by repeated scandals and legal settlements. Institutions considered “too big to fail” have become inefficiently large and complex, yet market forces do not force them to break up as they continue to have access to easy debt funding.

Admati described in an op-ed why and how banks should withhold payment of dividends until they build up their equity levels. In her view, banks should use their profits to make loans or other investments or to pay down some of their debt. In a TEDxStanford talk, she also explains in layperson’s language the concept of equity, especially how it applies to homeowners.

Conflicts of interest

Admati portrays banking as fraught with conflicts of interest. “Those who take or allow excessive risks do not bear the sufficient responsibility for the risks or their consequences, and those who are harmed have too little control (or may not realize that they are harmed),” she wrote in her upcoming paper.

On top of this, she said, those responsible for the economic downturn still have not learned all the lessons. When Congress passed the Dodd-Frank Act a few years ago as a way to tighten industry regulations, it gave authority to regulators but did not guarantee that they use those powers effectively or efficiently.

“More effective regulation of the mix of funding, so-called leverage, used in banking is highly cost effective relative to alternatives, and might reduce the need for more costly interventions. Yet the opportunity for major reform to improve the system has been missed so far,” she said.

One reason is politics. Admati said the symbiotic relationships between banks and governments have been barriers to reform – for example, the financial industry engages in intense lobbying and influence peddling. Politicians don’t challenge banks often for fear that banks would not fund favored causes, including campaign contributions, she added.

For the general public, the issues seem so complex and the risk so abstract that many people are reluctant to engage politically on the issue.

“Despite anger about the financial crisis and the enormous harm it caused, the issues and the details of the regulations are not widely understood. This situation allows misguided policies and recklessness to persist,” she wrote.

Admati calls for a radical reform, not a tweak, of capital regulation controlling the funding mix of financial institutions. The devil is clearly in the details, she said, and regulators can do much better on behalf of the public.

The case for worthy loans

Bank loans are critical for small businesses and consumers, Admati said. But among the harmful consequences of too much borrowing and flawed incentives – at times due to the design of regulations – banks too often appear uninterested in doing the work involved in making appropriate loans.

As she pointed out, even former Federal Reserve Chair Ben Bernanke recently had a mortgage loan rejected. Starting a business, Federal Reserve Chair Janet Yellen noted recently, seems to have become more difficult.

Banks take big risks in other ways by investing in financial securities, high-interest credit card loans and subprime auto loans, according to Admati. As the housing crisis illustrated, excessive lending can harm both the borrowers and the broader economy.

“Better regulation would produce a more stable financial system where banks would be more likely to make the kind of loans and investments that build and expand economic opportunity for society as a whole,” she said in a recent debate in the New York Times.

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