Shudder

When She Talks, Banks Shudder

By BINYAMIN APPELBAUM

Bankers are nearly unanimous on the subject of Anat R. Admati, the Stanford finance professor and persistent industry gadfly: Her ideas are wildly impractical, bad for the American economy and not to be taken seriously.

But after years of quixotic advocacy, Ms. Admati is reaching some very prominent ears. Last month, President Obama invited her and five other economists to a private lunch to discuss their ideas. She left him with a copy of “The Bankers’ New Clothes: What’s Wrong With Banking and What to Do About It,” a 2013 book she co-authored. A few weeks later, she testified for the first time before the Senate Banking Committee. And, in a recent speech, Stanley Fischer, vice chairman of the Federal Reserve, praised her “vigorous campaign.”

Dennis Kelleher, chief executive of Better Markets, a nonprofit that advocates stronger financial regulation, said Ms. Admati has emerged as one of the most effective advocates of the view that regulatory changes since the 2008 crisis remain insufficient. “She has been, as one must be,” Mr. Kelleher said, “dogged from the West Coast to the East Coast to Europe and back again and over again.”

Ms. Admati’s simple message is that the government is overlooking the best way to strengthen the financial system. Regulators, she says, need to worry less about what banks do with their money, and more about where the money comes from.

Companies other than banks get money mostly by selling shares to investors or by reinvesting profits. Banks, by contrast, can rely almost entirely on borrowed funds, including the money they get from depositors. Ms. Admati argues that banks are taking larger risks than other kinds of companies because they use other people’s money, and the results are that they keep crashing the economy.

Her solution is to make banks behave more like other companies by forcing them to reduce sharply their reliance on borrowed money. That would likely make the banking industry more stodgy and less profitable — reducing the economic risks, the executive bonuses and, for shareholders, both the risks and the profits.

“My comparison is to speed limits,” Ms. Admati said in an interview near the Stanford campus. “Basically what we have here is the market has decided nobody else should be driving faster than 70 miles an hour and these are the biggest trucks with the most explosive cargo and they are driving at almost 100 miles an hour.”

For all her success in stimulating debate, however, Ms. Admati and like-minded critics face long odds. Since the financial crisis, the government has already required banks to reduce their reliance on borrowed money by increasing capital standards, which dictate the share of funding that must come from equity. Mr. Obama recently described that increase as massive, and officials are considering further increases for the largest banks. But the net effect is tiny in comparison to the change sought by Ms. Admati. Officials worry that larger changes would hamstring American banks, driving business both to other kinds of domestic financial firms and to foreign rivals.

In his speech, Mr. Fischer said Ms. Admati’s arguments made sense in principle. “At one level, the story on capital and liquidity ratios is very simple: From the viewpoint of the stability of the financial system, more of each is better,” he said. But the United States, he said, was constrained by practicality. If other countries aren’t willing to impose stricter capital requirements on their own banks — and they don’t appear to be — then unilateral increases would hurt the American banking industry and the broader economy.

Andrew Metrick, a Yale finance professor, said that such rules could also push activity into the less regulated corners of the domestic financial system.

He compared the situation to a pair of parallel highways, echoing Ms. Admati’s metaphor. “If you lower the speed limit on one highway, you’ll have fewer accidents on that highway,” he said. “But the other road will just get more crowded.”

Ms. Admati compares this logic to letting American manufacturers pollute so that they can compete more effectively with companies in China. And she says she is looking for new ways to press her fight. In February, she debated bankers at the World Economic Forum in Davos, Switzerland. In May, she delivered a 15-minute TED talk to an audience at Stanford. Next year, she is planning a conference in Washington. She says it’s hard to imagine a return to the kind of theoretical work that absorbed her before the crisis.

“This is not fun,” she said of her campaign. “But I know that this is a bad system. There is no justification for this — zero. The only reason we are staying where we are is that the status quo has staying power. And if we are stuck with the status quo, then we are going to have to suffer the consequences.”

Before the financial crisis in 2008, Ms. Admati spent most of her time working with complicated financial models. She had never paid much attention to banking or to public policy. But as the crisis unfolded, she began reading and talking with colleagues — “like a doctor from another field of medicine visiting the emergency room,” she said — and grew increasingly disconcerted by what she learned.

Even after the crisis, banks continue to rely on debt financing far more than other kinds of corporations. Last year, the eight largest American banks together derived less than 5 percent of their funding from shareholders, according to Thomas M. Hoenig, vice chairman of the Federal Deposit Insurance Corporation. The average equity financing for nonfinancial corporations was about 60 percent.

Ms. Admati said she started asking one question repeatedly: Why were banks behaving so differently? Companies with more debt are more vulnerable to financial setbacks. Banks were in the danger zone, so why not raise more equity?

Four years later, she says she’s still waiting to hear a good answer. She recalled the explanation in one prominent banking textbook, which she read in 2010, as a particular spur to action. “It was shocking,” she remembered. She said she went to the office of a Stanford colleague, her frequent collaborator Paul Pfleiderer, and told him: “Something is very wrong. I’ve never heard so much nonsense in all of my life.” She still becomes visibly angry as she recalls the conversation. “They are denying what we know about financial markets. It’s like they are saying gravity is not a force in nature.”

Ms. Admati decided to enter the public square because she felt that academics and policy makers weren’t listening. “The Bankers’ New Clothes,” which she wrote with Martin Hellwig, an economics professor at the University of Bonn, proved a turning point in her campaign. But the first step was much smaller. She was not sure how to reach a popular audience, so in 2010 she enrolled in a program that teaches prominent women to write opinion articles. Her first, published in The Financial Times in the fall of 2010, was a letter co-signed by 19 other academics that criticized an international agreement on minimum bank capital standards as “far from sufficient to protect the system from recurring crises.”

Banking is the only industry subject to systematic capital regulation. Borrowing by most companies is effectively regulated by the caution of lenders. But the largest lenders to banks are depositors, who generally have no reason to be cautious because federal deposit insurance guarantees repayment of up to $250,000 even if the bank fails. This means the government, which takes the risk, must also impose the discipline.

In the decades before the financial crisis, banks gradually convinced regulators to reduce capital requirements to very low levels. In the aftermath, banks acknowledged that some increases were necessary — they had just needed enormous bailouts, after all — but they fought to minimize those increases. The day after Ms. Admati’s article ran, the same paper ran one by Vikram S. Pandit, then the chief executive of Citigroup, arguing that the proposed standards were excessive. “The last thing the global economy needs is another economic dampener,” Mr. Pandit wrote.

The industry has benefited from, and sometimes encouraged, public confusion. Banks are often described as “holding” capital, and capital is often described as a cushion or a rainy-day fund. “Every dollar of capital is one less dollar working in the economy,” the Financial Services Roundtable, a trade association representing big banks and financial firms, said in 2011. But capital, like debt, is just a kind of funding. It does the same work as borrowed money. The special value of capital is that companies are under no obligation to repay their shareholders, whereas a company that cannot repay its creditors is out of business.

The industry’s more serious argument is that equity is more expensive than debt. If governments require banks to raise more equity, the industry warns, the results would be higher interest rates, less lending and slower economic growth.

A 2010 analysis funded by the Clearing House Association, a trade group, concluded that an increase of 10 percentage points in capital requirements would raise interest rates by 0.25 to 0.45 percentage points.

This, in the view of Ms. Admati, is a small price to pay for fewer crises. She notes that debt is cheaper than equity largely because of government subsidies — not just deposit insurance but also tax deductions for interest payments on other kinds of debt — so more equity would basically transfer costs from taxpayers to banks. Even in the short term, she says, the economic impact may well be positive. A study last year by Benjamin H. Cohen, an economist at the Bank for International Settlements, found that banks with more capital tended to make more loans.

Ms. Admati says large banks should be required to raise at least 30 percent of their funding in the form of equity, about six times more than the current average for the largest American banks. This would not affect the ability of banks to accept deposits; it would not even affect their borrowing from other sources. Instead, she says, banks should be required to suspend dividend payments, thus increasing their equity by retaining their profits, until they are sufficiently capitalized.

“There is no more clear case of choosing the banks over the public than the payouts,” she said of regulators’ decisions to let banks resume dividend payments after the crisis. “They can tell you all day long they’re working on ‘too big to fail,’ but while they’re working on it they cannot allow banks to be getting closer to failure.”

She freely concedes that there is no particular science behind her 30 percent equity figure. The point, she says, is that 5 percent is the wrong ballpark. The proper baseline, in her view, is what the market imposes on other kinds of companies.

“We have too much belief that we can be precise,” she said. “I don’t mean 20 percent. I don’t mean 30 percent. I mean add a digit. I mean a lot more.”

She has been to Washington repeatedly in recent years, but when she returned last month to testify before a Senate committee, she approached the trip with the intensity of a last chance. She made dinner plans with a senior policy maker the night before her testimony and spent the morning before her appearance meeting with congressional staff members. When she learned she had missed a chance to meet with Senator Elizabeth Warren, the Massachusetts Democrat who is a leader in the push for stronger financial regulations, she doubled back after the hearing to plead for a second chance, standing antsy outside the office, checking messages.

As she waited, she said she was glad that policy makers finally seemed to be listening. But, she said, she was frustrated by the lack of progress and not sure about how to press ahead.

Then she excused herself and went to check once more to see if Senator Warren was available.