BONN â€" In the arcane world of bank regulation, it is a provocative idea: Force bankers to plow all their profit back into their balance sheets until they have built up such a large pile of capital that no one need ever again worry about bailing them out.
That is a central proposal put forth by Anat Admati and Martin Hellwig in their book ‘‘The Bankers’ New Clothes: What’s Wrong With Banking and What to Do About It.’’ Released in February and now ranked 10th on Amazon’s list of books on banking, the book is attracting attention not only for arguments that seem designed to give bankers nightmares but also for its attempt to make a dry subject appealing to ordinary people. It is bank regulation as beach reading.
Among well-known economists at prestigious institutions, it is unusual to write a book featuring a fictional character â€" in this case, one named Kate, whose mortgage and borrowing habits are used throughout the text to explain the principles of leverage.
But Ms. Admati, a Stanford University professor, said that she and Mr. Hellwig, co-director of a branch of the Max Planck Society research organization in Bonn, became frustrated as, they perceived, policy makers and the news media swallowed arguments made by the banking lobby that, in their view, were ‘‘absolute nonsense.’’
Ms. Admati refers to it as ‘‘big shotness,’’ the tendency for people to concede to the wealthy and powerful. ‘‘The problem with banking is people give it a pass on everything,’’ she said by phone from California. ‘‘All of a sudden the laws of nature don’t apply. It’s staggering.’’
‘‘Buzz’’ may be too strong a word for the reaction generated by a book that is about topics like risk-weighted assets, return on equity and the deliberations of the Basel Committee on Banking Supervision. But, in a sign that ‘‘Bankers’ New Clothes’’ has been attracting notice, it has been cited in a speech by Thomas M. Hoenig, vice chairman of the Federal Deposit Insurance Corporation, and an academic paper by Andy Haldane, executive director of financial stability at the Bank of England. Paul A. Volcker, former chairman of the Federal Reserve, and Mervyn A. King, former governor of the Bank of England, supplied blurbs for the book’s jacket.
Ms. Admati and Mr. Hellwig are prominent among a larger group of economists who have been arguing for years that banks remain dangerously dependent on leverage and prone to disasters that taxpayers would have to clean up. Lately, there are signs that their arguments are prevailing against those of the banking industry.
Last Tuesday in Washington, the Federal Reserve Board, the F.D.I.C and the Office of the Comptroller of the Currency proposed doubling the minimum amount of capital that the eight largest United States banks would be required to maintain.
The day before, the Basel Committee on Banking Supervision, a group of regulators and central bankers that sets regulatory benchmarks for the United States, Europe and most large countries, issued a discussion paper indicating that it may also advocate higher capital requirements for the largest global banks, in addition to rules already agreed upon.
‘‘Clearly, after what happened in the last six years, the global consensus has been that there wasn’t enough capital,’’ Stefan Ingves, governor of the Swedish central bank and chairman of the Basel Committee, said by phone. ‘‘There will be a continuous debate about what the level of capital should be.’’
The central issue in ‘‘Bankers’ New Clothes,’’ as well as in policy-making circles, is how much of their own money banks should be required to use when making loans or other investments, and how much they may borrow. The Basel Committee rules as written now would allow banks to borrow up to 97 percent of the money they lend or invest. The remaining 3 percent, known as a leverage ratio, would have to be capital, either retained bank profit or shares of the bank’s own stock. The new Fed proposal would raise the leverage ratio for large United States banks to 6 percent.
Banking industry representatives argue that a 3 percent leverage ratio, which would not become mandatory until 2019 under the Basel rules, is already enough and that it is too early to raise it further.
‘‘We need to give it some time,’’ said Kevin Nixon, deputy managing director of the Institute of International Finance, an organization that represents most of the world’s largest banks. ‘‘There is an urgency to keep doing things when we haven’t yet seen the reform actually become embedded in the system.’’
Requiring banks to maintain too much capital would stifle lending and hurt economic growth, Mr. Nixon said, repeating an assertion made often by the banking industry. ‘‘You need to think very carefully about the impact on economy,’’ he said.
That is one of the arguments that Ms. Admati and Mr. Hellwig find spurious. A 3 percent leverage ratio, they write, means that a bank goes bankrupt if the value of its assets loses more than 3 percent in value. The only people who benefit from so much risk, they say, are the bankers, and only because they assume that taxpayers will bail them out.
Many of the banks that required bailouts after the financial crisis in 2008 were highly leveraged, including UBS in Switzerland and Hypo Real Estate in Germany. Lehman Brothers, whose failure helped precipitate the crisis, was also highly leveraged. Ms. Admati and Mr. Hellwig advocate a leverage ratio of 20 percent or even 30 percent to protect society from the economic destruction created by a large-scale banking crisis. Banks themselves would never grant loans to companies that had only 3 percent equity, the authors write.
They argue that there is no reason why healthy banks cannot raise more capital by retaining profits or selling new shares. The only thing banks and their shareholders would lose is the de facto free insurance against losses that they receive because governments cannot allow them to fail.
‘‘Society would obtain large benefits for free,’’ write Ms. Admati and Mr. Hellwig, whose professional association began when she consulted him on her doctoral work in the 1980s. ‘‘The Bankers’ New Clothes’’ grew from a paper â€" Ms. Admati calls it a manifesto â€" that they wrote in 2010 with two other Stanford professors, Peter M. DeMarzo and Paul C. Pfleiderer.
There is a large body of research showing a correlation between excessive leverage and failure of banks like Dexia, the Franco-Belgian institution that required a second bailout in 2011. But many economists are frustrated by the quality of the public debate about regulation, said Simon Taylor, director of the master of finance program at Judge Business School at Cambridge University.
‘‘The academic world has been exasperated at the quality of the arguments being put forward by the banks and the fact they weren’t being challenged,’’ said Mr. Taylor, who has praised ‘‘Bankers’ New Clothes’’ on his blog. ‘‘That’s where a lot of the anger â€" I think it is anger â€" is coming from. Basic principles of corporate finance were not being acknowledged.’’
The book is also aimed at what the authors consider an ill-informed media. Mr. Hellwig said he was surprised to learn from Ms. Admati that many American business journalists spent college studying subjects like literature rather than economics. German financial journalists, on the other hand, tend to have an economics background, he said. Policy makers, they say, are also often misinformed.
‘‘When Anat went to discuss these things in the political arena, she found there were many people who simply did not understand,’’ Mr. Hellwig said in an interview conducted by this reporter, a former history major. Mr. Hellwig, whose cluttered office is in a spacious villa a short walk from the Rhine, has long been involved in public policy. He serves on panels that advise the German government on economics and the European Commission on competition policy.
But he said he had no illusions about the ability of economists to influence public officials, who in Germany and France have tried to shield banks from too many leverage restrictions. ‘‘What is important,’’ Mr. Hellwig said, ‘‘is to contribute to the public debate and force the vested interests, force the politicians, to be clear on why they are doing these things and bear the cost of having the weaker arguments.’’
