53 of 59 people found the following review helpful
Compelling approach to ending too big to fail, improve financial stability,
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This review is from: The Bankers' New Clothes: What's Wrong with Banking and What to Do about It (Hardcover)
Excellent book written for a general audience explaining why big, highly leveraged banks are bad for the economy. Then they assert that requiring banks to raise more capital by issuing stock and less through borrowing will be extremely beneficial for the financial system.
This seems too simple to be true and the most helpful negative review has called it "overly simple". I strongly disagree. I think it is just simple enough. Simple is good. Complicated rules, such as the Volcker Rule, will be gamed, evaded and lobbied to irrelevance. The presentation in the book is somewhat oversimplified but there are lots of footnotes that go into greater depth and elaborate the point plus references that support them.
Why hasn't such simple logic been followed already? The authors describe how bankers benefit from the current system of extremely high leverage and from the implicit promise of taxpayer bailouts. They also argue that their proposal -- which they have been making academically and to regulators and politicians for a few years -- has been opposed by entrenched banking interest. Also, the general public doesn't understand these issues or of banking in general. They argue that this in part because bankers promote confusion. This book is written to combat that. "We want to encourage people to form and to trust their opinions, to ask questions, to express doubts, and to challenge the flawed arguments that pervade the policy debate. If we are to have a healthier financial system, more people must understand the issues and influence policy."
I think they do a great job of explaining the problem in very clear and understandable terms to people with no prior knowledge without oversimplifying. For readers who want to delve more deeply, they have excellent footnotes and references. I am involved in the field and find the references and excellent compendium of sources, some of which I already knew but some which I am very glad they have pointed me to.
Their central premise is that a simple measure -- requiring banks to raise more funds as equity capital -- issuing stock instead of borrowing -- would greatly improve the stability of the banking system. They also address the "bugbear" that doing so would reduce economic growth. Essentially, we can have our cake and eat it too.
In their words "if banks have much more equity, the financial system will be safer, healthier, and less distorted. From the society's perspective, the benefits are large and the costs are hsrd to find: there are virtually no tradeoffs."
The message is quite strong and they seem quite alarmed about the current state of affairs "Today's banking system, even with the proposed reforms, is as dangerous and fragile as the system that brought us the recent financial crisis." But their writing is quite dry and matter-of-fact. I think they do a wonderful job of explaining the essence of banking and the problems leverage creates to people without a lot of financial knowledge.
I found their message to be quite persuasive and compelling.
Addendum: Many of claims in negative reviews are refuted by the authors in this (fairly short) document.
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Showing 1-5 of 5 posts in this discussion
Initial post: Apr 23, 2013 6:02:07 PM PDT
Last edited by the author on Apr 23, 2013 6:03:16 PM PDT
"Why hasn't such simple logic been followed already?"
Because banks can leverage themselves through equity offerings in exactly the same way they can leverage themselves through "pure" debt. The form of leverage is less meaningful than the the total amount of leverage at the institution. The implicit guarantees by the government to the banks also tend to erase the usually difference betwen equity and debt.
The problems in the system go deeper and these sorts of easy answers are useless. Take a look at the MF global scandal. Over a billion dollars went missing from customer accounts. Nobody can explain where the money went. Not a single person has been charged with a crime or is likely now to ever be charged with a crime. If over a billion dollars can disappear out of customer accounts at a broker with the government unable to bring a single charge or hold a single person criminally responsible at the firm, there are problems in the system that no amount of new regulations can fix.
My view is that there are only things that influence the decisions of bankers: the chances of personal financial ruin and the prospect of going to jail. If the chances of either happening are silm, no amount of regulations will have any effect on the system.
In reply to an earlier post on May 7, 2013 9:44:15 AM PDT
While I agree with some of what you say, I think you have some misconceptions.
"banks can leverage themselves through equity". You are suggesting that it makes little difference whether they borrow or raise shareholder capital. I don't see that at all. It determines who is taking the risk. If you are suggesting that bank executives control the bank (not shareholders) and they still have perverse incentives, I'd agree. But if shareholders have more at risk, there is a better chance the bank as a whole will be better managed.
Second, it makes s huge difference in a crisis. If banks have little equity, the risk of a systemic crisis is much higher. If the money is raised as equity, it is like the tech bubble, a lot of shareholders lose but no systemic crisis.
Also, while MF Global was appalling and I agree it is very unfortunate no one was criminally prosecuted, the money didn't actually "disappear" and customers are ultimately coming out close to whole.
In reply to an earlier post on May 8, 2013 12:41:07 AM PDT
"You are suggesting that it makes little difference whether they borrow or raise shareholder capital. I don't see that at all. It determines who is taking the risk. If you are suggesting that bank executives control the bank (not shareholders) and they still have perverse incentives, I'd agree. But if shareholders have more at risk, there is a better chance the bank as a whole will be better managed."
There is a false assumption in that. People act as if banks only issued common stock or took out loans. But these days, its a lot more complicated. For years, the banks have been creating instruments that blur the line between "equity" and "debt". At the peak of the crisis, a certain bank raised "equity" by issuing instruments that paid a fixed rate of return, were convertable into common stock and included warrents on top of all that. People often think that there is a simple distinction between "loans" and "equity", but these days that is far from the case. Its worse in the case of the banks because the risk profile of loans to banks isn't all that different than the risk profile of equity. In a non-bank business failure, the business itself usually has a basic value which goes to those who hold loans. But a failed bank has very little of value at all. Its almost impossible for those holding the loans to escape the same risks associated with equity.
In my opinion, the people who run these institutions today are the traders. The tail wags the dog and the executives usually have little power. I think that any solution has to involve making the senior traders at these banks hold equity and hold risk in case of the bank failing. Somehow the people taking the risk decisions at banks have to be put at personal financial risk if the bank fails.
"Second, it makes s huge difference in a crisis. If banks have little equity, the risk of a systemic crisis is much higher."
I agree with that. But its not a matter of equity. Its a matter of leverage. Banks can leverage themselves via things that look like equity in the same way they can leverage themselves through loans. The whole idea of common stock in banks is rather strange. The shareholders are basically giving the bank money to put at indirect third-party risk in exchange for *nothing*.
"If the money is raised as equity, it is like the tech bubble, a lot of shareholders lose but no systemic crisis."
That example doesn't work. Banking is by its nature an interdependent business which is different than a tech company building products.
We didn't reach systemic risk by accident. It came about in large part to fix a series of eariler problems in banking where insitutional/regional/national risk was the problem. It used to be that the economic conditions in one region of the country could drag down the banks in that part of the country. Recession happens. Businesses get it trouble. Banks get in trouble. Money stops being loaned which makes the local economy even worse.
The theory was that regional/individual institution risk in banking could be mitigated by spreading risk all across the system. And it worked reasonably well. The problem was (and is) that financial businesses react to ANY reduction in their risk by taking on MORE risk. And since systemic risk is hard to measure, the banks keep pushing for more leverage and more risk. And when it went too far, we got a systemic failure. And if we go too far in trying to "solve" the systemic problem, we will end up once again with the regional/institutional stability problem.
"Also, while MF Global was appalling and I agree it is very unfortunate no one was criminally prosecuted, the money didn't actually "disappear" and customers are ultimately coming out close to whole."
The money did actually disappear. The last round of customer compensation was paid for out of a legal settlement. Money is being reclaimed and clawed back to fix the problem which is not the same thing as getting the actual money back or actually explaining where/how/why the customer money went out of the company. How much people get back also depends on which country they were in. The way I would look at it is that the account holders are being treated effectively as senior creditors.
In reply to an earlier post on Jun 17, 2013 2:56:43 AM PDT
Mark T says:
"worked reasonably well'? NO--it was exactly this supposed "spreading of risk" across the system that put us where we are.
In the supposed bad old days of "regional" risk--not so long ago they couldn't go across state lines--the Bank of America did just fine making loans to Californians. We never had anything like these crises and bailouts in the 50s and 60s. Then the megalomaniacs (the clown who did BofA in was a lawyer) who thought it would be cool to loan big money to the despotic regimes of the world. Con-man Wriston of Citibank led the way proclaiming that "countries don't go out of business". Since then, we have careened from one crisis to another, the Mexican rescue of 1982, the equity crash of '87, we had to bail Mexico again after Shill Clinton got NAFTA through, the Asian meltdown, Long-Term Capital (instructive as the strategy that crashed the firm was based on the theory of the latest winners of the Nobel Prize in Economics) and finally TARP. The entire scam of globalization is one gigantic fraud, the economics texts that STILL teach the demented theoretical fantasy that "spreading risk" stabilizes the system don't even mention "Too Big To Fail" (neither Krugman's nor Mankiw's $175 texts address it) in reality this has opened up the entire system to repeated episodes of spreading "contagions".
In reply to an earlier post on Jun 19, 2013 10:09:39 AM PDT
There were any number of regional bank mini-crisis events. California's size and economic diversity made the problems difficult to happen within California. But California is not the entire country.
We did not have these bailouts in the 1950s or 1960s. But what we did have in that era was a tightly controlled financial system that in essence guaranteed profits to banks. There were no bailouts because there were continuous subsidies to the banking system. Going back to that system is certainly an option. But it has a high price.
"The entire scam of globalization is one gigantic fraud, the economics texts that STILL teach the demented theoretical fantasy that "spreading risk" stabilizes the system don't even mention "Too Big To Fail" (neither Krugman's nor Mankiw's $175 texts address it) in reality this has opened up the entire system to repeated episodes of spreading "contagions"."
"Too important to fail" has been a basic part of economics since the 1930s. Since the 1930s there has always been an implicit guarantee that the government will pay any price to avoid a systemic banking collapse out of fear of another Great Depression. If risk is spread, systemic risk rises. If risk is concentrated, regional risk rises. There is no perfect solution because there is no way to eliminate risk entirely.
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