The most dangerous woman in America — and why conservatives should listen to her

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What Anat Admati, a Stanford University finance professor, is saying about megabanks shouldn’t be controversial: make these institutions less likely to (again) implode and crash the US economy by making them less reliant on borrowed money for lending. Or to flip it around, megabanks should have to raise six times as much of their funding in the form of equity as they currently do. Now as Admati told New York Times reporter Binyamin Appelbaum, her 30% equity target isn’t a hard number:

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.”

The megabanks are no fans of this idea. They argue “holding” more equity capital would increase funding costs, lower return on equity, and force them to cut back on lending. But imagine how much stronger the US economy would be today if we had avoided the Great Recession. As Charles Calomiris and Allan Meltzer note in a Wall Street Journal op-ed earlier this year, all the big New York banks with 15% equity or more made it through the Great Depression, and that the “losses suffered by major banks in the recent crisis would not have wiped out their equity if it had been equal to 15% of their assets.”

Anway, Admati and Martin Hellwig counter all the common objections in their “The Bankers’ New Clothes: What’s Wrong With Banking and What to Do About It.” And a paper from which the book is derives offers this chart:

0215banks

And this from the Appelbaum piece:

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.

The alternative to weather-proofing the megabanks with equity capital is, what, relying on regulators and politicians? Yet four years after the passage of Dodd Frank,the feds recently found the “living wills” submitted by the 11 most complicated megabanks to be totally inadequate. The documents fail to, as the FDIC’s Thomas Hoenig puts it, “convincingly demonstrate how, in failure, any one of these firms could overcome obstacles to entering bankruptcy without precipitating a financial crisis.”

Are higher equity requirements the magic bullet? I don’t know. Calomiris and Allan Meltzer suggest additional options such as requiring banks to maintain cash reserves at the Fed and “contingent capital” funding requirement where a special debt would convert to equity whenever “the market value ratio of a bank’s equity is below 9% for more than 90 days.” Another intriguing idea comes from economists Atif Mian and Amir Sufi, authors of “House of Debt.” They advocate a new kind of “risk sharing” mortgage contract where falling home prices would reduce payments and principal for borrowers, and lenders would share in the capital gains from rising prices. What all these policies have in common is creating a less debt-driven and risky financial system. That idea combined with smarter macroeconomic stabilization policy by the Fed — such as nominal GDP targeting — might mean the most recent economy-shattering financial shock could be our last.

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