Principles of Banking: A Review of a Review of Adamati & Hellwig’s The Bankers’ New Clothes

The capacity of an economy to grow is dependent on the nature of financial institutions besides other factors. Financial institutions, particularly banks, channelise savings (via deposits) into investment (via loans for economic activity). That is, they play a vital societal function. Hence, Roger Myerson, the author of the review essay, writes: ‘So there is an essential role for public regulation of banks: to maintain stable trust in channels of credit that are vital to our society’ (p. 197). This blog post is a review of a review essay of Admati and Hellwig’s The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It by R. Myerson in the Journal of Economic Literature.

Banks are unlike other economic entities. Manufacturing firms do not require public trust to carry out their daily operations in the same way as banks do. If the public find the banks to be untrustworthy, no deposits will be made and nor will anyone borrow. This affects the saving-investment intermediation and consequently other ‘real’ economic activities (agriculture, manufacturing and services) are affected. What happens in the banking system does not stay within it but it both directly and indirectly impacts other parts of the economy ‘ a financial contagion, as it is called. Thus, banks need to be publicly regulated. And, as Myerson points out, ‘the reliability of any regulatory system must depend on broad public monitoring of the regulatory process itself’ due to the vast wealth involved in the business of banking (p. 198). This is not all. According to Myerson, ‘any meaningful financial regulatory reform must include a clear explanation of its principles to millions of informed citizens and investors’ (p. 198).

For Amati & Hellwig, the problem is that bank owners have lost the incentive to keep their banks afloat. Why is this so’ First, the owners’ stake in the bank’s investments has dwindled. In other words, banks possess less equity. Equity is the difference between the value of assets or investment the bank owns and all the debt liabilities the bank owes to its depositors and other creditors (p. 198). From about 25 percent equity capital in early 20th century, it fell to about 3 percent or less in 2008 (pp. 198-9). A large value of equity capital signals to the depositors that their deposits will be safe. This provides reassurance due to two reasons ‘ (1) ‘the probability of investment losses large enough to affect the depositors become smaller when the bank has more equity’ and (2) ‘the owners who control the bank have more incentive to avoid risks of such large losses’ (p. 199). The second reason for a decline in bankers’ incentive is the ‘creation of government deposit insurance programmes in America and elsewhere’. Now, the risks of the owners of the banks get transferred to the government and therefore to the tax-paying public. Hence, as Myerson writes:

‘when creditors are publicly insured, bank default risk becomes a public problem. Thus, the requirement that banks should have adequate equity has become a responsibility of public regulators. (p. 199)

Given the wider economic function banks play and the contagion effects, it is important that banks are not allowed to fail. Admati & Hellwig recommend banks’ equity levels to be 20-30 percent of their total assets (p. 209).

A firm can finance its investment by issuing debt or equity. The proportion of equity to total liabilities (sum of equity and debt capital) matters because the risks are borne by different groups. Government deposit insurance enables banks ‘to borrow at low rates that do not properly respond to the greater risks that their creditors must pay when the bank has less equity’ (p. 200).’ Also, financial fragility intensifies if tax laws encourage financial institutions to use more debt than equity in financing investments (p. 201).

When short on cash, the banks go to the Central Bank, the lender of last resort, for assistance. It lends only to solvent banks. An assessment of solvency requires the Central Bank to be able to assess the assets of the bank ‘ whether its collateral is ‘good’ and whether it has positive equity (p. 202). This also points to the importance of capital regulation for banks as it is ‘fundamental to liquidity’. A slight digression is in order here. Owing to the fundamental role of liquidity in all economic processes, the provider of liquidity ought to be publicly controlled. In fact, as Myerson rightly states:

‘the role of monitor and lender of last resort should be recognized as a vital natural monopoly, maintain costly expertise to provide public information, but with monopoly power that should be publicly controlled. (p. 203)

The lender of last resort is therefore consequent on the central banks’ ability to monitor the equity of banks. Thus, measurement (financial accounting, imputing values, risk weighting and so on) assumes great importance (pp. 203-9).

To conclude, banks perform a fundamental socio-economic function in channelling savings into productive investment. The ability of banks to conduct their business depends on public trust. Public trust in turn depends on the proportion of equity capital to total liabilities which is deemed acceptable by the financial regulator. This acceptable ratio is computed by private experts who do not fully take into account the social cost of a low ratio. Given the high possibility of moral hazard in banking and the threat of financial contagion, it is imperative that there is public regulation of banks with the principles made transparent to the tax-paying public who have a direct stake as savers and an indirect stake as contributors to the deposit insurance.