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Finance and Democracy

This is a syndicated repost courtesy of The Baseline Scenario. To view original, click here. Reposted with permission.

Roger Myerson, he of the 2007 Nobel Prize, wrote a glowing review of The Banker’s New Clothes, by Admati and Hellwig, for the Journal of Economic Perspectives a while back. Considering the reviewer, the journal, and the content of the review (which describes the book as “worthy of such global attention as Keynes’s General Theory received in 1936″), it’s about the highest endorsement you can imagine.

Myerson succinctly summarizes Admati and Hellwig’s key arguments, so if you haven’t read the book it’s a decent place to start. To recap, the central argument is that under Modigliani-Miller, the debt-to-equity ratio doesn’t affect the cost of capital and therefore doesn’t affect banks’ willingness to extend credit; the real-world factors that make Modigliani-Miller untrue (deposit insurance, taxes, etc.) rely on a transfer of value from another party that makes society no better off.

Myerson’s main point, accepting Admati and Hellwig’s position, has to do with the politics of bank regulation. Financial crises can have huge costs for society, as we know, and fundamentally they are about a failure of trust—trust that the banks are solvent, or that the bankers know what they are doing. As capital regulation has become more technical and complex, we have been increasingly asked to simply rely on the expertise of the regulators, since we cannot rely directly on the disclosures provided by the banks.

In 2008, we learned that relying on the regulators was a catastrophic error. Six years later, however, we have no better solution. Politicians, regulators, and bankers have engaged in a great deal of ritual display to try to make us believe we should trust them (resolution authority! living wills! clearinghouses! Volcker Rule! contingent convertible bonds!). But the basic nature of Dodd-Frank was more complexity, more rulemakings, more back-alley rulemaking, and less transparency. Dodd-Frank has probably helped in several ways, but it hasn’t given us any reason in general to have more confidence either in banks or in regulators. Instead, I think most people throw up their hands and move on because they have no other option.

As Myerson writes:

“With so much money in the banking system, our hope that regulators and officials will not be induced to falsely certify unsafe banks must depend on confidence that a failure of appropriate regulation could be discovered, reported in the press, and understood by voters well enough to cause a ruinous scandal for the responsible officials. . . .

“If there are abstruse financial transactions that generate risks which cannot be adequately represented in standard public accounting statements, then perhaps such transactions should be off limits for banks that are in the business of issuing reliably safe deposits.”

In other words, it’s not just that complexity can cause banks to blow up. It’s also that complexity makes it impossible for regulators to monitor banks, which is a critical ingredient in the financial crises that we all supposedly want to avoid.

Besides the primary reason for higher capital requirements—safer banks—this is the political reason for higher capital requirements (and other simple, structural fixes like smaller banks). More equity, based on standards that cannot be gamed by banks, is crucial to ensuring that the safety of the financial system does not depend on a secretive cadre of technocrats whose personal interests (whether or not they act on those interests) are decidedly aligned with those of the banks they regulate. Otherwise, as Myerson warns, “if nobody outside of the elite circles of finance can recognize a failure of appropriate regulation, then such failures should be considered inevitable.”

Wall Street Examiner Disclosure: Lee Adler, The Wall Street Examiner reposts third party content with the permission of the publisher. The opinions expressed in these reposts are not those of the Wall Street Examiner or Lee Adler, unless authored by me, under my byline. I curate posts here on the basis of whether they represent an interesting and logical point of view, that may or may not agree with my own views. Some of the content includes the original publisher's promotional messages. No endorsement of such content is either expressed or implied by posting the content. All items published here are matters of information and opinion, and are neither intended as, nor should you construe it as, individual investment advice. Do your own due diligence when considering the offerings of information providers, or considering any investment.

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