Big banks are as risky as ever, economist warns

(MoneyWatch) Anat Admati can foresee the country's economic ruin -- or its salvation. However the chips fall, she'll be able to say "I told you so."

In an important new book due out next month, "The Bankers' New Clothes," the Stanford University economist warns that the U.S. banking system is as precarious today as it was before the 2008 housing crash. And given the vulnerability of the country's biggest banks, it won't take the kind of gale-force financial winds that blew down the global economy roughly four years ago to trigger another collapse.

"Even without a crisis, it's a system that is living on the edge," Admati said in an interview.

The result: Banks often lend too much, leading to periods of wild speculation, or too little, as lenders pass up worthy loans because they can make larger profits on riskier activities. In both cases the economy suffers. Banking is "too highly indebted, and it leaves people subject to all kinds of ups and downs and booms and bust," she added. "There are indications that the financial system is becoming bigger and bigger and more knotted up in the sense of interconnectedness."

Admati warns that one explosion could topple the entire system.

If it does, the catalyst is almost certain to be the same ingredient that brought down the financial system -- debt. Big banks are "addicted" to it, said Admati, who notes that no other corporations come close to borrowing as much money as lenders do. Immediately before the financial crisis, many large banks had debts amounting to 97 percent of their total assets. To this day, banks rely almost entirely on debt to fund their business, commonly having less than 10 percent in equity, and often as little as 5 percent. 

That shift happened over many decades. Paradoxically, it also occurred in part because of government efforts to protect banks from losses, such as with the expansion of deposit insurance in the 1930s.

"From putting in a safety net in order to have a safer system, we ended up enabling more borrowing," Admati said. "As a result, equity levels declined almost continuously from 25 percent down to the single digits over the 20th century. And then, in the last 20 or 30 years, banks have found clever ways to borrow through derivatives markets and other innovations. That allowed more borrowing and also more hiding of leverage."

Debt-laden banks have little margin for error. When financial conditions sour and their assets lose value, they can get into trouble in a hurry. Indeed, this debt "overhang" can destabilize lenders even before a downturn hits. That's because borrowing amps up a bank's financial gains -- including executive bonuses -- while losses are shared by creditors. Given this misalignment in incentives, borrowing begets borrowing.

"We have to fight back against this addiction to debt," Admati said. "It's as if someone is driving too fast -- we have to slow them down. There's too much collateral damage."

Admati, who co-authored the book with economist Martin Hellwig of the University of Bonn in Germany, is no ordinary Cassandra. For one, she's among the country's most important financial economists. In the years since the subprime meltdown, Admati, 56, also has emerged as one the most respected and pointed critics of Wall Street, using commonsense arguments -- sharpened by her economic expertise and copious empirical research -- to debunk bankers' claims that the financial system is safe.

Second, she's not merely a critic, but rather comes bearing solutions -- solutions she says would help banks perform their essential function of funneling money into the broader economy while also defusing the risks ticking away within the financial system. 

One such approach is to limit banks' exposure to their financial partners. That would reduce the danger of a single bank "counterparty" falling into trouble and causing a shock wave to ripple throughout the entire industry, as AIG's insolvency did in 2008. But even that would only make for a smaller crater, not deter banks from taking risks in the first place.

In Europe, meanwhile, regulatory authorities have proposed walling up banks' retail lending, deposit-taking and other government-backed businesses to insulate them from their far riskier investment banking activities, like trading. Yet that approach also has glaring weaknesses.

Admati's preferred fix is for big banks to use much more equity to fund their assets and investments and much less debt. After all, just as homeowners are less likely to get foreclosed the more equity they have in their houses, so banks are more likely to remain solvent the more equity they have in their business. Enhancing a financial institution's ability to absorb losses by requiring them to hold more equity also reassures a lender's depositors and creditors, guarding against the kind of crippling bank runs that paralyzed the financial system in September 2008.

Beyond such practical remedies, Admati offers non-financial experts and other laypeople a framework for evaluating the arguments that bankers make when they feel threatened by new rules -- that they are too complicated to be regulated like other businesses. "There is a pervasive myth that banks and banking are special and different from all other companies and industries in the economy," Admati writes. "Anyone who questions the mystique and the claims that are made is at risk of being declared incompetent to participate in the discussion."

This narrative pushed by the financial industry over the years -- a set of ill-founded claims that go unchallenged by most politicos, regulators and financial experts -- gives the book its title and guiding metaphor. Strip it away and Wall Street, the emperor of finance, stands exposed.

Alarmingly, however, an uncritical faith in the purported uniqueness of banks still pervades policy-makers' thinking on how to police the financial sector. Under this view, promoted before and after the crash by bank CEOs, top government officials and government regulators alike, restrictions on bank borrowing are an unacceptable hindrance. It would curb lending and harm economic growth, the story goes.

As Admati notes, that is an old refrain. To cite but one example, bankers made similar claims after the FDR administration cracked down on lenders following the Great Depression. As economic historian Charles Geisst recounts, here's what J.P. Morgan Jr. (scion of the banking empire that bore his father's name) said in 1933 in opposing a law that separated investment banks from commercial banks: "If we, for instance, should be deprived of the right to receive deposits... we should very probably have to disband a large part of our organization and thus should be less able to render in the future that important service in the supply of capital for the development of the country which we have rendered in the past."

Another standard tactic by big banks is to simply deny they have a problem. For instance, JPMorgan Chase (JPM) CEO Jamie Dimon has referred to what he calls the company's "fortress balance sheet" in asserting that it is safe. Not so, according to Admati, who characterizes JPMorgan as "highly vulnerable" and says it imposes a "significant risk" on the global financial system. She says that's because some of the risks that make the company dangerous -- about a trillion dollars' worth -- aren't reflected in its balance sheet. We shouldn't be surprised. Banks such as Bear Stearns and Lehman Brothers were considered healthy not long before they vaporized during the financial crisis. 

"One of the reason banks aren't safe is because we're not even sure what's in there -- they're very opaque and hard to read," Admati said, adding that big lenders have yet to recognize the full extent of their mortgage and other losses. "By the time we discover things, it's too late."

Many approaches have been proposed to safeguard the financial system, including requiring banks to hold more capital and setting up exchanges for trading derivatives. Yet in the U.S., such efforts have hit a wall, with much of the 2010 Dodd-Frank financial reform law yet to be implemented amid a bank industry lobbying blitz to blunt the statute.

Admati acknowledges that more substantial financial reform may be impossible without political reform, or at least an admission by official Washington that the task of fixing the banking system is far from complete. The sweeping regulatory correctives that followed the Depression took multiple laws and many years to implement. In that sense, genuine reform is possible only if Dodd-Frank represents a first step rather than the last word.

"We can have a financial system that works much better for the economy than the current system -- without sacrificing anything," Admati concludes. "But achieving this requires that politicians and regulators focus on the public interest and carry out the necessary steps. The critical ingredient -- still missing -- is political will."