Anat Admati: The Failure of Financial Regulation

Anat Admati is the George G.C. Parker Professor of Finance and Economics at the Graduate School of Business, Stanford University. Here she is interviewed by Marshall Auerback, the Institute for New Economic Thinking’s Director of Institutional Parternships.

Lambert here: Since it’s the weekend and nobody’s watching, I’ll dip my toe in the waters of finance; maybe at some future point I’ll actually wade into the shallow end of the pool! This interview contains an interesting, nuts and bolts discussion of the Cyprus and London Whale debacles, and it’s worth a listen to see how a finance professional recapitulates them; I found it interesting that Admati uses the phrase “political economy” unapologetically.

Both Auerback and Admati agree that we seem not to learn from past crises. The interview concludes:

AUERBACH: What sort of new economic thinking do you personally think we should be doing to be consistent with our mandate?

ADMATI: Well, I think the economic thinking is partly [an issue of] how the political economy of the regulation, how to make certain regulations work, in an environment where there’s a combination of self-interest and confusion. So the issue is not necessarily in this case some of the new economic thinking is really kind of back to basics type of thinking, and not getting confused by narratives that are actually flawed, and then sort of taking it to the policy context, how to make it the economics and the political economy work.

I would ask “work for whom?” since assuredly our current arrangements work for some, but never mind that. Because Jeebus, since I’m new to this stuff, can it really be true that the idea pf environments marked by “a combination of self-interest and confusion” isn’t already a basic working assumption in the discipline of economics? (Especially since we see, in accounting control fraud, which played such a role in creating the great financial crisis, that actors create confusion deliberately, out of self-interest.) Isn’t the real world just like that?

Anyhow, the material Admati supplies along with the interview is really interesting, and much more tool focused than the interview. I fixed on the phrase “flawed claims” — I’m a magpie for glittering phrases — because I thought Admati meant financial claims, like debts, which, being false, would have to be unravelled sooner or later, taking down the whole system, destruction, collapse, Götterdämmerung, SHTF, etc.

But no! Admati means claims as a rhetorician would understand the word: An assertion that something is or should be true, like “It is the case that Jamie Dimon is a lying weasel, albeit charismatic in his own way,” or “Poor people must be punished.” And that led me to this paper, “The Parade of the Bankers’ New Clothes Continues: 23 Flawed Claims Debunked,” by Admati and Martin F. Hellwig of the Max Planck Institute for Research on Collective Goods (!). The authors seem to have aggregated false claims made as feedback to their book, and reinserted, as it were, the system’s outputs back into the system itself, in the form of a paper. Here’s the PDF of the paper, and here are the 23 claims. I know 23 is rather a lot, but you’ve probably heard a shouting head on the TV emit all of them, at one time or another.

List of Flawed Claims
Claim 1: Capital is money that banks hold or set aside as a reserve, like a rainy day fund.

Claim 2: Requiring banks to hold reserves equal to 15% of their assets does not make them safe. Therefore, a capital requirement of 15% is useless.

Claim 3: The argument for requiring banks to have substantially more equity is only based on the so-called Modigliani-Miller theorem, which does not apply in the real world because its assumptions are unrealistic.

Claim 4: The key insights from corporate finance about the economics of funding, including those of Modigliani and Miller, are not relevant for banks because banks are different from other companies.

Claim 5: Banks are special because they produce (or create) money.

Claim 6: Increasing equity requirements would reduce the ability of banks to provide people with deposits and other short-term claims that are liquid and can be used like money.

Claim 7: Increasing equity requirements is undesirable because the funding costs of banks would increase.

Claim 8 : Increased equity requirements would lower the banks’ return on equity (ROE) and therefore harm shareholders and make inve stors unwilling to invest in banks’ stocks.

Claim 9: Increased equity requirements would force banks to make fewer loans.

Claim 10: Increased equity requirements would induce banks to lend less, and this would be harmful for the economy.

Claim 11: Higher equity requirements are undesirable because they would prevent banks from taking advantage of government subsidies and would force them to charge higher interest on loans.

Claim 12: Banks cannot raise equity and will have to shrink if equity requirements are increased; this will be bad for the economy.

Claim 13: Increasing equity requirements would harm economic growth.

Claim 14: Basel III is already tough, doubling or tripling previous requirements. Banks have much more capital [equity] now than they had earlier and they are safe enough.

Claim 15: Basel III is based on careful scientific analysis of the cost and benefits of different levels of capital requirements, whereas the rough numbers of those who advocate much higher requirements cannot guide policy because they are not supported by scientific calibration.

Claim 16: Because capital requirements should be adjusted to risk, it is essential to rely primarily on requirements that are based on assigning risk weights to assets.

Claim 17: Instead of issuing more equity, banks should be required to issue long-term debt or debt that converts to equity when a trigger is hit, so-called “contingent capital” or co-cos.

Claim 18: The Dodd-Frank Act in the US has done away with the need to bail out banks; if a bank gets into trouble, the FDIC will be able to resolve it without cost to the taxpayer

Claim 19: If capital requirements are increased, banks will increase their “risk appetite,” which may make the system more dangerous.

Claim 20: If capital requirements are increased, bank managers will be less disciplined.

Claim 21: Tighter regulation is undesirable because it would cause activities to move to the unregulated shadow banking system.

Claim 22 : Since banking is a global business, banking regulation must be coordinated and harmonized between regulators worldwide. It is important to maintain a “level playing field” in global competition.

Claim 23 : Stricter regulation is would harm “our” banks; instead we should be supporting them in global competition.

One and all false!

I’m a sucker for numbered lists — “23 Weird Claims Banksters Make” — because they’re easy to refer to, and to chain together. We can claim, for example, that if Claim 18 is false, as Admati claims it is, then when the next — inevitable! — financial crisis comes along, we are so hosed. (For some definition of “we,” of course; the lesson of the 2008 crash and the subsequent and continuing depression, is that “this is working out well for them”, where “them” is some “us” unlikely to be us.)

Let’s look at one debunking in detail: Claim 22. (I picked this one because it sounds like the sort of claim that TPP advocates would make:

Flawed Claim 22: Since banking is a global business, banking regulation must be coordinated and harmonized between regulators worldwide. It is important to maintain a “level playing field” in global competition.

What’s wrong with this claim? The claim, discussed in Chapter 12, is false. If some countries foolishly allow their banks to pursue very risky strategies and to borrow excessively, this is not a reason why other countries should do the same. Each country should be concerned with how much of a risk from its banks it is willing to accept, just as each country has its own building codes, consumer safety standards, environmental regulation and energy policy. We would not allow chemical companies to pollute rivers and lakes simply because the industry maintains that somewhere in the world another country is allowing these things. The search for “level playing fields” in global competition is highly damaging if it leads to a race to the bottom, where each country ends up fighting stricter regulation on behalf of its members of the industry.

The claim is interesting, because it’s a policy claim that “must” be true. Admati’s responses are No, things don’t have to be this way. But who is deciding the “must”? Let me highlight one sentence in her debunking.

We would not allow chemical companies to pollute rivers and lakes simply because the industry maintains that somewhere in the world another country is allowing these things.

Well, if you’re drafting the TPP, or supporting it, that’s exactly what “we” “would” allow. Friends of the Earth:

To avoid the most serious environmental harms, the TPP negotiators must [ha] address the following issues, among others:

  • Reject the proposed TPP investment chapter that would authorize foreign investors to bypass domestic courts and bring suit before special international tribunals biased in favor of multinationals. Foreign investors could seek awards of money damages, of unlimited size, in compensation for the cost of complying with environmental and other public interest regulations. They could even seek compensation for lost future profits.

If the international tribunals are biased toward investors, then indeed “we” will have had exactly the kind of race to the bottom that Admati so justly decries and, history being written by the winners, “should” have had it, too. Because the free market!

* * *

So, and most definitely FWIW, I think Admati’s done the world a great service by aggregating the “flawed” — I keep writing “false” — claims of banksters and their apologists and shills. It’s great to have all the lies gathered in one place and debunked.

However — and here is where the obvious riposte is “Read my book!” OK! OK! — when speaking of political economy, conflict goes down to the bone, down to very simple, one syllable words like “we,” “work,” “must,” and “should,” which turn out to be highly contested. Because TINA?

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About Lambert Strether

Readers, I have had a correspondent characterize my views as realistic cynical. Let me briefly explain them. I believe in universal programs that provide concrete material benefits, especially to the working class. Medicare for All is the prime example, but tuition-free college and a Post Office Bank also fall under this heading. So do a Jobs Guarantee and a Debt Jubilee. Clearly, neither liberal Democrats nor conservative Republicans can deliver on such programs, because the two are different flavors of neoliberalism (“Because markets”). I don’t much care about the “ism” that delivers the benefits, although whichever one does have to put common humanity first, as opposed to markets. Could be a second FDR saving capitalism, democratic socialism leashing and collaring it, or communism razing it. I don’t much care, as long as the benefits are delivered. To me, the key issue — and this is why Medicare for All is always first with me — is the tens of thousands of excess “deaths from despair,” as described by the Case-Deaton study, and other recent studies. That enormous body count makes Medicare for All, at the very least, a moral and strategic imperative. And that level of suffering and organic damage makes the concerns of identity politics — even the worthy fight to help the refugees Bush, Obama, and Clinton’s wars created — bright shiny objects by comparison. Hence my frustration with the news flow — currently in my view the swirling intersection of two, separate Shock Doctrine campaigns, one by the Administration, and the other by out-of-power liberals and their allies in the State and in the press — a news flow that constantly forces me to focus on matters that I regard as of secondary importance to the excess deaths. What kind of political economy is it that halts or even reverses the increases in life expectancy that civilized societies have achieved? I am also very hopeful that the continuing destruction of both party establishments will open the space for voices supporting programs similar to those I have listed; let’s call such voices “the left.” Volatility creates opportunity, especially if the Democrat establishment, which puts markets first and opposes all such programs, isn’t allowed to get back into the saddle. Eyes on the prize! I love the tactical level, and secretly love even the horse race, since I’ve been blogging about it daily for fourteen years, but everything I write has this perspective at the back of it.


  1. Pwelder

    Granted this is mainly Yves’ blog, and Yves has a pretty good handle on the banking/finance end of things, and Lambert wants to be polite. But there’s no need for him to be overdoing it with the false modesty bit.

    You want to get tooled up for finance? This stuff at bottom isn’t rocket science. (The professors and the derivatives mavens throw around a lot of fancy math, but that’s mainly for show.) Get to where you really understand present value – (1 + r) to the Nth, and all that – learn to read a balance sheet, to the point where you know in your bones the difference between liquidity and solvency, and you’re pretty much there. A bright sixth grader could pick it up in a day or so.

    To comment usefully on the role of finance in society, you need one central insight: There are parts of the economy where the let-er-rip, try-it-and-see-what-happens, go-for-the-gold entrepreneuralism of the type adored by the Wall Street Journal’s editorial page does more harm than good. Cowboy capitalism is a great thing in areas like consumer electronics, not so good in areas like the water works or the electric grid.

    Time was you could have an argument about whether finance is more like consumer electronics or the water works. Rubin, Greenspan, Summers and their acolytes have settled the issue, very decisively. We should all be grateful.

    1. F. Beard

      Cowboy capitalism is a great thing in areas like consumer electronics, not so good in areas like the water works or the electric grid. Pwelder

      Why then do we have the same money system for BOTH?! Money from the monetary sovereign should be used to promote the general welfare, not prop up an inherently crooked, unstable credit cartel for the benefit of the so-called creditworthy.

    2. Lambert Strether Post author

      Oh no. Yves does the simplest explanation of ratios and MEGO (My Eyes Glaze Over). The modesty is not feigned! I can do the “political” part of “political economy” pretty well, and you’ll notice that’s what I focused on, but the “economy” part is still a barely open book. (May be a good thing, if economics needs, as Admati says, to get back to basics; I don’t have a lifetime of bullshit to slough off.)

      1. Pwelder

        Well, if you’ve got the horses to latch onto Admati’s stuff, you’re either lucky or good. It works either way.

        That’s a great PDF link, by the way. It’s apparently been around since early June, and that’s the first I’ve seen it. Many thanks.

    3. s spade

      The banking solution is ridiculously simple. Limit banks to one location and limit banks to buying Treasury securities and making loans against real estate located within their local area. Cap their size. Allow those one location banks the Fed backstop. Let the rest of finance do whatever it wants and blow itself up and force stockholders and creditors to live with the results. No bailouts for them.

      Why on earth should banks be permitted to gamble with insured deposits? Why should they be selling insurance or making loans to Mexico? The only reason they are permitted to do any of these things is political corruption. Vote to unseat every Congress critter (regardless of party) until it stops. There is no alternative.

  2. craazyman

    i don’t know who the ‘we’ is everybody keeps talking about.

    There’s no doubt “they” learned from their past mistakes, they learned they’d get bailed out no questions asked by the world’s ditch diggers and nail salon girls.

    Who’s the “we”? That’s the hardest question. All the math is easy — any bonehead can learn differential equations and regression techniques — if you don’t think too hard about the “we”.

    You have to start there and then all the answers change. But most people just lose it and fall back on the math.

    1. Banger

      I like that question. Of course sometimes “we” is the editorial “we” that keeps cropping up way too much for my taste–media personages keep saying “we know….” and I do a double take and wonder editorial we or real we? Mostly disagree with the medias assumption that we all share the same understanding of what went on. I think it is best we limit the word “we” and here I’m speaking about myself too.

      The fact is that one (maybe we should return to “one”) ought to understand that the public (if that’s what the meaning of “we” is) is not even close to united either in what they accept as true or in matters of philosophy. If someone’s goal is to make as much money as possible in as short amount of time as possible risk and externalities be dammed then that person will have nothing in common with someone like me, who is completely uninterested in wealth accumulation and just wants to live an enjoyable life in convivial company. There can be no “we” between people of radically different life philosophies. There can be no discussion of climate change or banking regulation or justice or anything between us because we do not agree on fundamental principles. And the public today, is in that situation as can be seen by the struggles in Washington where everyone, I can assure you, is always trying to make a deal to get on the same page or so it was at one time. Conformity not struggle is the Washington way.

      1. allcoppedout

        90%of almost any ‘we’ get simple logical choices wrong – as in Wason tests (google one and try – ‘we’ won’t be much good as a group).

      2. diptherio

        There can be no “we” between people of radically different life philosophies.

        I get what you’re saying, and mostly agree, but this sentence rubs me the wrong way. I think there can be, and is, a “we” between people of radically different life philosophies. Think of your family. In mine there are plenty of people whom I disagree with on fundamental matters…but there is still a “we.”

        The “we” that I wish would get more acknowledgement is not some abstract concept, but the simple fact that, for better or for worse, we all share a planet together. It would be nice if we could start treating others (including those with whom we have philosophical differences) as members of a common human family. Like it or not, we’re all stuck here together.

        1. Banger

          I think you make a good point here. However I don’t quite agree. Many families, including my own, only have a formal relationship but no real relationship and the tendency, over time, is for families to atomize. I have experienced traditional societies and their family structures. In these societies if you are a member of the family you never have to worry about your well-being–if you lack something a wealthy member is obligated to help you–that person may make life miserable but, in a traditional community, to ignore a needy relative is a way to lose status. Not so in the USA.

          The American ideal is that everybody is “independent” this is not true in any way but the myth is a requirement. We are very reluctant to help each other. I think this is dangerous and counter to human nature–we want to connect. Our current culture is moving us towards collective insanity.

  3. zygmuntFRAUDbernier

    I think that, for whatever reason, the US regulators are not very effective. The Telegraph had a story in August on US prosecutors seeking to extradite two JPM London bankers; also, the Senate report and enquiry into the Londown Whale was tougher and more probing than what the Bank regulators are known to have done:

  4. clarence swinney

    Annualized spending growths by term
    Bush I—5.4%
    Bush II—7.3%–8.1%
    Obama—1.4% estimated

    1. Lambert Strether Post author

      Yes, exactly. Amati’s 23 claims are embedded in countless narratives that form the discourse of the political class, modulo outliers, when the subject matter is banking. Now we have the (analytical) problem scoped, we’ve got our arms around it. When you hear one of these claims, you’re hearing bullshit purveyed by a bullshit artist. That’s a useful tool.

      1. craazyboy

        If we could only get the POTUS, Fed, OCC, SEC, DOJ, Congress, SCOTUS, DOD, CIA, NSA, NATO, BIS, World Bank, and UN to believe it’s bullshit. I think the FDIC is maybe on our side, because they know they are on the hook for making it all work out.

        1. craazyboy

          Forgot TSec, the rest of the central banks, IMF, and the other 200 world governments. Little Peoples too. Tibetan Monks, of course.


  5. Susan the other

    So far regulation has just added another layer of complexity, or more accurately, obfuscation. Nobody has reined in the frenzied chasing after returns, which is risky. So no one has reined in the derivatives trade. Interesting that our Sec of the Treasury, a banksters bankster himself, is leaking statements that if regulation fails we will soon have to look for an alternative of some kind. Guaranteed returns? How are they gonna do that? So prescient of you Lambert, the TPP clauses to protect capital do sound like a good clue as to the future of guaranteed returns. Such a dangerous idea when returns are as diminished as oil and the only way we are now staying afloat is to reinflate asset values. Somebody needs to point out that you can’t regulate a system that no longer works.

    1. Lambert Strether Post author

      That is a neat formulation. How can “we” guarantee “our” returns? That is the problem of the rentier class, and it’s existential. Given that the market state is run for their benefit, that is its task in their eyes.

      I wonder if there’s a definition or school of thought that understands markets without all that stupid “free market” stuff. Buying and selling, for sure, but under conditions of “self-interest and confusion,” where self-interest introduces power relations, and confusion introduces information asysmmetries and fraud.

      Maybe to a rentier the ideal market is a lemon market?

      I’m focusing on the rentiers because, well, they’re running the world right now.

  6. F. Beard

    Because Jeebus, …. Lambert

    Shame on you!

    The Lord Jesus has said in advance that He’ll forgive blasphemy against Him, so isn’t it a bit low and cowardly of you to take advantage of that forgiveness?

    Must you try to fit in with a crowd that I suspect you are better than?

    Or maybe I should just quit slumming since when it comes to ethical money creation, Progressives are regressive.

      1. F. Beard

        No reply was needed. A red-face in private was all I expected. I don’t like embarrassment myself so I don’t dish it out lightly but you keep persisting with behavior that is beneath you.

        Do your worst. I’m done anyway.

        1. craazyman

          dude, chill out already. It’s only the internet. :)

          Turn it over to JC Himself and let it go. He can handle it better than you or me.

  7. allcoppedout

    Admati sounds as third-rate as you can get, with ‘amazing’ statements like you should expect more risk with higher returns. Good Lord, she’ll next be telling us short-priced favourites are more likely to win horse races than 100 – 1 shots! She follows this with a lower standard than NYT reporting on the JP Morgan stuff. Time wasting gossip I’m afraid Lambert.

    Clever money got into Cyprus to take high yields and out before haircuts. Bookmakers don’t lose because they don’t bet, but they need others to risk money for the game to flow so they can skim it. So what game was set up in Cyprus and who were the winners? What information would we need to find out and how is it being hidden? I’d prefer people taking shots at this than economics professors who tell me what I could read in newspapers.

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