"The financial system is close to the abyss"

Prof. Anat Admati

Prof. Anat Admati will tell the "Globes" 2014 Israel Business Conference that the lessons of the 2008 bank crisis have not been learned.

For the full schedule and registration: Israel Business Conference, or telephone *5988.

Banks are like a car going too fast. So long as it arrives safely and on time, everything is all right. The problem is that when it goes too fast, it burns the engine and can explode. Were all living the illusion, like in 2006, when we thought that everything was all right, but the entire financial system is now living dangerously and close to the abyss, is the pessimistic forecast Prof. Anat Admati of Stanford University gave Globes in an interview.

Admati is one of todays prominent academic figures in the US economy, and a bitter critic of the global banking system and the regulation on it. She co-wrote the bestseller and award-winning The Bankers New Clothes, published in 2013, and was named as one of this years 100 Most Influential People by Time Magazine.

She will speak on the "The future of the banking system" session on Sunday December 7 at 1:30 pm.

Globes: Are the banks more stable now than before the 2008 crisis?

Admati: Although there are banking criteria about which it can be said that things have changed. However, some indices indicate that the banking system is at even greater risk than before, especially regarding the weight of the big banks. If we compare the figures to 2006, the findings are not encouraging. In 2006, the average size of a bank was $1.36 trillion; today it is $1.76 trillion. These are scary sizes, no matter how you look at it. It should be remembered that the big banks are global banks, operating in scores of countries, and legally, they cannot fall. The banks are also interconnected, so a blow to one will hurt the others.

Where are there other problems?

The banking system is opaque. For example, its hard to know the risk in derivatives and each banks exposure to another bank. Some of fragility in banks is because we dont know all the risks. The result is that everything could suddenly collapse like a house of cards.

Banking supervision has greatly tightened since the crisis. Hasnt that changed anything?

The regulatory changes did not greatly improve the situation. Current regulation is not always focused, and not always good. If regulators really wanted to control the system, they would do more.

Although there is tighter regulation, and even claims that it is too tight, you think it should be tightened further.

I do not favor regulation for the sake of it. Some regulatory demands are too costly and inefficient in a cost-benefit calculation. Take for example the regulation requiring the submission of a document detailing how the banks are supposed to undergo bankruptcy. These documents have thousands of pages on how banks will undergo bankruptcy without government aid. But the document is complex and its hard to know how it will fare the test of reality. I favor more basic regulation, like rules for permissible driving. Simple regulation can be the most effective.

You talk about driving, but how is this expressed in banking? Where should the requirements be?

Lets start with the simple things - equity. The banks equity requirements should be greatly raised. This is the most basic thing to change, and it will simultaneously correct several distortions.

Capital requirements have been raised in recent years. Isnt it enough?

The banks capital ratios are really low, for which there is no justification. Due to the low capital requirements, a situation has resulted in which the banks have no motivation to rely on their equity for financings, because they have cheaper financing sources, such as deposits and bonds. The result is that banks are financing a huge balance sheet of activity from cheap and subsidized sources. Their financial management is unhealthy and inefficient. Banks shareholders are ostensibly in a good position, but the taxpayers and depositors should also be remembered, because if something goes wrong, they will pay the price.

If that is the case, who benefits?

Very few people benefit from the system. The biggest beneficiaries are the banks executives and their main investors, who receive a kind of subsidy for cheap financing. The result is an obese, inefficient and unreasonably distorted system, which does not support the economy and economic stability.

What do you think about bankers pay?

The salary structure is problematic. In the current mechanism, there is very high pay in good years, but it does not fall in bad times. Executives dont even pay a price for fraud and criminality. Even multibillion-dollar fines remain at the level of the corporation, and do not affect executive pay.

I present frightening things

Admati was born in Kiryat Gat and has been a member of the Stanford University faculty for 30 years. Since 2010, she has run a public debate on financial regulation, particularly on capital requirements. The breakthrough came with the publication of her book, The Bankers New Clothes: what is wrong with banking and what to do about it. Last April, she was honored by Time Magazine as one of the years 100 Most Influential People, becoming the first Israeli on the list. It has been written that she is the economist who wrote that bankers are naked.

In late November, Admati won another honor, when Foreign Policy included her in its list of 100 Leading Global Thinkers. The list includes a diverse range of opinion-setters, leaders, and activists from around the world. Admati was selected for her thinking on global banking supervision, saying that her ideas had even reached the ears of US President Barack Obama.

However, alongside the honors and appreciation Admati has garnered, she also encounters criticism for her approach. Although she is sure of her approach, she admits that she has faced attempts to shut her up. I present frightening things, I know that there are many parties who want me to shut up, and banks have friends in academe. Fortunately, I have tenure and the freedom of speech, she says.

The truth is that my criticism is directed more at policymakers than the banks. The banks do what is best for their insiders. If we give someone an incentive to drive fast, and give him an escape hatch from the car if it explodes, why shouldnt he drive fast? Therefore, the question is not why is he driving fast, but why is allowed to drive at high speed.

You frequently mention politics and its ties with banking. Where do you see this?

When I began dealing with banking, I look at things as a pure economist, but the more I get around, I see how strong and influential politics is. I am not the only person who thinks this. There was a senator who said in 2009 that bankers ruled Washington. The connection between politicians and bankers sometimes has a financial component.

What do you mean?

There is a very toxic combination of incomprehension and politics. Politicians do not always understand banking and the jargon, and bankers exploit this for their own ends. To this, you should add the very strong lobbying by the banks, and sometimes even the media prefers not to criticize the banks. There are a lot of problem to which I was exposed in this context.

Zombie banks constantly gamble

One of the main things that Admati proposes is to greatly increase banks capital requirements. For example, in the banks core capital adequacy ratio in Israel is 9%; Admati says that it should be 20-30%.

The capital adequacy ratio you propose is reminiscent of ordinary corporate leverage. Shouldnt the banks have different capital ratios from other companies, otherwise what is the difference between banks and companies in other industries?

Banks assume debt by obtaining deposits and they are special in that, compared with other ordinary companies. In addition, there is no justification for having such a high leverage like they want. In principle, they should have financing costs like ordinary commercial companies. There is no justification for having such a risky financing mix and for their financing cost to be subsidized. If banks would finance more of their activity from their equity, they would take greater account of the risk. Take Google (Nasdaq: GOOG) for example. It and other companies have little debt. Companies can always invest their profits back in the company. Banks can also do this, and use their profits as a source for increasing their capital and for growth, and the system would be healthier.

Nonetheless, you propose drastically raising the capital adequacy ratio to 20-30%. Arent you afraid of the consequences?

It all depends how you manage it, but I believe that proper management can only be for the good. Among other things, it will reveal which banks are good and healthy, and which are weak to the point of being zombies - the walking dead. Significantly raising the capital will force the banks to raise capital on the market, which will help show their value. If investors arent prepared to give a lot of money, the question will be raised, why. If the banks are no good and they have a problematic balance sheet, in which the assets are less than the liabilities, well know it when they try to raise capital. If a bank is a zombie it wont be able to raise capital, and I fear that there are a lot of banks like that.

Why undermine such banks and cause them to fail? Wont that hurt the economy?

A zombie bank cannot issue new credit, so it is already not a source of oxygen for the economy. Zombie banks only continue to gamble with more and more money to try and cease being a zombie, while simultaneously not recognizing their losses in their balance sheets, in order to avoid collapse. This is not healthy. Banks often do not recognize their losses, such as from mortgages, and they are presented as if the debt will be repaid. There is a lot of manipulation in the ability to repay is measured.

You are describing a situation in which banks are teetering on image distress. If that is case, why are their creditors calm?

Some bank creditors are depositors, and they are especially easy and nice creditors, who are not concerned, and let the banks do what they wish with their money. If the banks creditors treated the banks like the banks treat their borrowers, the situation would be different. The banks know how to demand collateral from their borrowers, they monitor them, and they are quick to make demands on the basis of the risk. But the banks have many crazy creditors, such as depositors, who have no collateral against their money, only a promise that everything will be all right.

Where do you think the next crisis will come from?

Its hard to know, and it is also hard to know when it will happen. It could come in ten years. The crisis could come from sovereign debt. The US debt problem could return, because it was never really solved, or the crisis could come from other problem debt, such as student loans or large car loans. It is important to note that a small collapse can trigger a great crash, because the system is fragile and interconnected. Most of all, there is a lack of transparency in mapping the situation, which is part of the problem.

Will things change after the next crisis?

I am not sure that things will change after another crisis. There will always be spin and excuses for a crisis, and well still be told tall tales. In the end, the public is ready to absorb the fall of banks. In contrast, the public is not prepared to accept a plane crash, which is why plane safety rules are so strict and there are black boxes, so there will be greater transparency and responsibility. Contemporary banking is different, but maybe if enough people wake up and demand change from the politicians, there will be more hope for change.

The eurozone is one of the most dangerous places

Admati says that the global banking system suffers from problems, and she sees the main risk in Europe. The eurozone is one of the most dangerous places. Im a bit anxious about the situation there, she says.

Why?

The European banking system is in bad shape and its not easy to change things there, because there is an unhealthy symbiosis between governments and banks, which need each other and everyone is connected through the currency. This is economically unstable and unhealthy.

Where else are there problems?

The situation in China is also sensitive. There was an over-boost there and it is unclear who will suffer or what the repercussions will be when the Chinese bubble bursts.

What about Israel?

I know both the current governor [Karnit Flug] and her predecessor [Stanley Fischer], and they understand the matter, and are aware of the different issues. There are a lot of elements for regulation besides capital, such as competition, fees, and what fields banks can engage in. I am not sufficiently familiar with the situation in Israel, but I am going to meet during my upcoming meeting at the Bank of Israel, and I will have an opportunity to discuss all the issues.

Israeli banks are proud that they were barely hurt by the 2008 crisis, so maybe were in good shape?

That does not mean that the situation is as good as it can be. The question is what are your standards for stability and health? When you drive fast, and avoid an accident, that does not mean that youre in good shape. Banks always say that they are stable, but what do healthy and stable mean? There are standards for stability. In general, under the current standards, Israels banks appear to be stable, but the most important thing is for regulators to keep their fingers on the pulse and verify that the system is healthy.

A lot of banking is unrelated to credit that contributes to the economy

There has been frequent criticism about Admatis attitude and her proposal to greatly boost banks capital requirements. One claim is that raising the capital requirements will result in banks not being able to extend credit at the current scale, resulting in a credit crunch. Admati dismisses the argument, saying, There is no reason for this to happen.

How can you know this?

Preventing such a situation depends on regulation and the motivation to let banks extend credit at reasonable terms, and prevent motivation to do other things. A lot of the banks activity has nothing to do with business credit or credit that contributes to the economy. The banks chase after returns, and they play with the little capital they have and with depositors money, which is the basis of their leverage. With the right business model and the right capital mix, there is no reason for a credit crunch.

In the last crisis, when capital requirements were lower, we saw a credit crunch.

The credit crunch we saw in the last crisis was because banks too little equity and too much debt, and they were losing money and could not continue lending. That is why the situation is the opposite of your argument. When there too little capital, risks are taken and money lost, a credit crunch is the result.

If the banks will greatly increase their capital, their return on equity will plummet and investors will flee from their investments. Isnt that dangerous?

The return on equity is not a criterion in itself, and it should also include the risk factor. The banks are currently showing a return on equity that is achieved at the price of a certain risk, and because of subsidies in raising debt. The important question is whether shareholders get a suitable return that covers the risk.

I want to remind you that, before the 2008 crisis, banks showed high returns and also distributed dividends, which is like throwing money to investors. But if you look over an eight-year period, despite the high returns, bank shareholders lost money and the executives profited.

Participants in the Next Generation Banking session at the Globes 2014 Israel Business Conference are Bank of Israel Supervisor of Banks Dudu Zaken, Prof. Admati, European Bank for Reconstruction and Development (EBRD) chief economist Prof. Erik Berglöf and a special adviser to its president, and Bank Hapoalim (TASE: POLI) chief economist Leo Leiderman and lecturer at Tel Aviv Universitys Berglas School of Economics . The moderator will be Globes banking and capital market correspondent Irit Avissar.

Published by Globes [online], Israel business news - www.globes-online.com - on December 3, 2014

Copyright of Globes Publisher Itonut (1983) Ltd. 2014

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Prof. Anat Admati
Prof. Anat Admati
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