”The Bankers’ New Clothes” Then and Now, with Professor Anat Admati

Introduction and Background

• The banking issues discussed are relevant globally, but the focus is on Europe and the US, where the speaker resides. (17s)
• The speaker's career took a turn after the 2007-2009 financial crisis, shifting from corporate finance to questioning the system and its flaws. (32s)
• The crisis led to bailouts, a housing crisis, and a recession, with lasting effects that are still felt today. (1m7s)
• Jamie Dimon's narrative about the crisis is that it was an unavoidable event, but the speaker disagrees, believing that the crisis was preventable. (1m51s)
• The speaker exchanged views with Jamie Dimon and argues that the narrative about the crisis matters, as it influences how to prevent future crises. (1m45s)
• The book "The Bankers' New Clothes" was intended to be published in 2023 but was delayed to 2024 due to recent banking events, such as the Silicon Valley Bank and Credit Suisse issues. (2m26s)
• Another common narrative in banking involves the concept of liquidity and panics, which the speaker will discuss further. (2m51s)

The 2007-2009 Financial Crisis and its Aftermath

• The Dodd-Frank Act was passed in response to the crisis, with President Barack Obama promising no more bailouts, but the speaker questions the effectiveness of this law. (3m21s)
• An inquiry commission was established six months after the signing of Dodd-Frank, and the majority report analyzed the causes of the crisis. (3m56s)
• The financial crisis was avoidable and reflected failures of government and governance, with governance being a broad issue affecting all institutions, public and private sector alike, encompassing power, constraints, information, and incentives (4m10s).
• Governance deals with the fact that some people have more power, information, and incentives that might include harming others, and this is a key theme in understanding the crisis (4m51s).
• Michael Lewis, author of "Liar's Poker," wrote that from the moment Goldman Sachs went public in 1981, Wall Street firms became "black boxes" with opaque risk, and shareholders had no real understanding of the risk-taking activities (5m28s).
• Lewis argued that the problem wasn't that Lehman Brothers was allowed to fail, but that it was allowed to succeed and grow in complexity without adequate understanding or regulation (5m51s).

The Bankers' New Clothes: Key Themes and Arguments

• The book "The Bankers' New Clothes" aims to teach the economics of banking and corporate finance in an accessible way, emphasizing that banks are not special except for what they are allowed to get away with (6m45s).
• The book's authors argue that the reason their views are not more widely accepted is due to the influence of bankers and the widespread misunderstanding of economics (7m24s).
• The book has received praise from reviewers, including Jean Tirole, a Nobel laureate, who called it a "must-read for concerned citizens," and Martin Wolf, who wrote that banks are not special except for their ability to get away with certain practices (6m20s).
• The book "The Bankers' New Clothes" has been updated with four new chapters, including one titled "Undermining Democracy and the Rule of Law," which explains why the system is still fragile and discusses central banks, bailouts, and the role of institutions (8m1s).
• The book explains the economics of debt, including corporate debt, household debt, and government debt, highlighting commonalities and differences between them (8m57s).

Understanding Leverage and Risk

• The concept of leverage is illustrated using the example of a fictional borrower, Kate, who buys a house with a mortgage, putting down 5% of the $400,000 price, and ignoring interest and time lapsing to show how risk is magnified through borrowing (9m32s).
• If the house value increases by 5%, Kate's return on investment is 100%, but if the house value decreases by 5%, she loses her entire $20,000 investment, and if it decreases by 10%, she becomes "underwater," meaning the house is worth less than the mortgage (9m59s).
• The concept of being "underwater" is analogous to an insolvent institution, and Kate's situation depends on the terms of the mortgage, which may allow her to walk away or require her to pay the mortgage out of her other assets (10m43s).
• If Kate defaults on her mortgage, it could be due to a liquidity problem, where she has assets but cannot access the cash to pay her debt, or a solvency problem, where she is unable to pay her debt due to a lack of assets (11m13s).
• A borrower who is unable to pay their debt may default, and it's essential to understand why default occurs, with solvency problems being a significant challenge, as an insolvent borrower can harm creditors or society if they don't default (12m25s).

Bank Runs, Solvency, and Liquidity

• Solvency problems can create liquidity problems, as seen in banking when depositors run, and banks may have solvency issues rather than just liquidity problems (12m52s).
• Balance sheets for banks show deposits as liabilities, colored red, and equity as assets, colored yellow, with deposits being a special type of debt that can be withdrawn at any time (13m28s).
• Bank runs are an extreme case of liquidity problems, where everyone wants their money at the same time, often due to concerns about the bank's solvency or fear of not getting their money before others do (13m48s).
• If a bank is truly solvent, it's rare for a sudden bank run to occur, and such events are often depicted in movies, such as "It's a Wonderful Life" (14m7s).
• The history of banking has seen many bank runs, often due to solvency problems, and over time, safety nets like deposit insurance and central banks have been introduced to alleviate concerns about bank solvency (14m34s).

Safety Nets and Moral Hazard

• These safety nets have been effective, but may have become excessive, allowing banks to take on more risk, and the example from "It's a Wonderful Life" illustrates the idea that depositors' money is invested in illiquid assets, such as mortgages (15m2s).
• The movie depicts a heroic banker, George Bailey, who pays depositors out of his own pocket, but in reality, this is unlikely to happen, and deposit insurance has been created to protect depositors (15m44s).
• The US created Deposit Insurance after the Great Depression and bank holiday, with the current official limit in the US being $250,000, although the government has bailed out banks beyond this limit, such as in the case of Silicon Valley Bank (SVB) (15m49s).

Deposit Insurance and Bank Resolution

• The FDIC resolves failed banks and supervises the process, which is different from a bankruptcy, a legal process for people who can't pay their debt (16m17s).
• Deposits are considered debt, but banks often view them differently, as depositors are passive creditors who rely on regulators to manage risk, allowing banks to be heavily indebted without feeling the same level of debt as other corporations (16m42s).
• John Stumpf, the CEO of Wells Fargo, made a claim in 2013 that the bank didn't have a lot of debt due to self-funding with consumer deposits, which is misleading as deposits are a form of debt (16m53s).

Central Banks, Money Creation, and Bank Equity

• Central banks create money, but banks do not, and the balance sheet of central banks is unique in that they can print bank notes, which are considered liabilities (17m41s).
• Banks are allowed to have single-digit amounts of equity and are heavily indebted, which is unusual compared to other corporations that typically fund with more equity, such as high-tech companies funded with venture capital (18m10s).
• Historically, banks had more equity, with some private banks in the mid-19th century having 50% equity and unlimited liability, but as safety nets expanded, banks were able to reduce their equity levels (18m36s).
• The expansion of safety nets has allowed banks to reduce their equity levels, with some banks, such as Barclays, having very low levels of equity compared to their total assets (19m12s).

Systemic Risk and Contagion

• The 2007-2009 financial crisis highlighted the fragility of banks, including Barclays, and the complexity of the financial system, which can be difficult to understand due to the numerous contractual links and connections between institutions (19m42s).
• The system's complexity can lead to a contagion mechanism, often referred to as "banking dominoes," where the loss of equity in one institution can take down the entire system (20m26s).
• The US government, referred to as "Uncle Sam," bailed out the banks during the crisis, raising the question of why banks do not have more equity (20m36s).

The Role of Government Guarantees and Bailouts

• Banks claim that equity is expensive, but this expense is subsidized by taxpayers, and it is unclear why equity is not expensive for other corporations that do not have 5% equity on a regular basis (20m42s).
• The example of a wealthy aunt guaranteeing a loan for her niece illustrates how riskless debt can lead to cheap loans and the ability to buy a house with no down payment and all debt, no equity (21m21s).
• This scenario is similar to the situation with banks, which have Uncle Sam as a guarantor, providing a safety net that comes in many forms, including deposit insurance, guarantees, and loss-sharing agreements (22m45s).
• The safety net can prevent bank failures but can also lead to moral hazard, as banks may take on more risk knowing that they will be bailed out (22m53s).
• The US government's Troubled Asset Relief Program (TARP) and other indirect ways of bailing out banks, such as investing in or taking over banks, demonstrate the various forms of government support for the banking system (23m32s).
• Nationalization of banks is not commonly practiced in the US, but it has been done in several European countries, where the government can instruct the central bank to make risky loans and provide backing for them, as seen during the COVID-19 pandemic and after the collapse of Silicon Valley Bank (23m51s).
• Central banks can provide liquidity support and act as lenders of last resort, offering subsidized and low-interest loans, such as the 1% loans given in Europe, and can also buy assets to grow their balance sheets (24m12s).
• The Federal Reserve and the European Central Bank (ECB) have the power to lower interest rates, making borrowing cheaper, and have used this power to expand their balance sheets, with the Federal Reserve's balance sheet growing from under $1 trillion to $9 trillion after the financial crisis and COVID-19 pandemic (24m39s).
• In the US, there are various lenders of last resort and guarantees that can step in to support the system, such as the FDIC, which started a program during the financial crisis to guarantee bonds raised by banks, including those that didn't have deposits (25m7s).
• This program allowed banks like Goldman Sachs, Morgan Stanley, and JP Morgan Chase to raise money in markets with FDIC guarantees, which they used to pay back the Treasury for bailout money received, allowing them to avoid restrictions on dividends and salaries (25m22s).

Zombie Banks and Accounting Practices

• The concept of "zombie" corporations or banks refers to insolvent entities that can persist without defaulting due to passive creditors and lack of regulatory action, which can lead to a dysfunctional banking system, as seen in the US Savings and Loan crisis and potentially happening now (26m10s).
• Zombie banks can pretend to be safe or solvent on their balance sheets due to accounting standards, such as those used in Europe, which can hide their true financial condition, as seen in the cases of Silicon Valley Bank and Signature Bank (27m7s).
• Audit companies like KPMG may not raise flags about failing banks, even if they are insolvent, as seen in the cases of several European banks that failed despite receiving clean audit reports (27m22s).
• Silicon Valley Banks had bonds that lost value and didn't have assets to pay their debts, leading to a run on the banks when people realized this (27m42s).
• The banks' disclosures are not transparent, making it difficult for investors to understand the risks, with even savvy investors like Paul Singer from Elliot Management expressing frustration (28m0s).

JP Morgan Chase: A Case Study

• An analysis of JP Morgan Chase's balance sheet in 2011 revealed that the bank had $4 trillion in assets, with a significant portion being trading assets, and not just loans and deposits (28m16s).
• The bank's balance sheet was presented differently in the US and Europe, with the US accounting system showing $2.4 trillion in assets, and the European system showing $4 trillion (28m52s).
• The bank's loans were less than its deposits, indicating that a significant portion of its assets were trading assets, rather than traditional banking assets (29m6s).
• Despite presenting itself as a traditional bank, JP Morgan Chase is actually a huge trading operation with a small banking component (29m19s).
• The bank's equity, referred to as the "Fortress balance sheet" by Jamie Dimon, was significant, but the bank has continued to grow and take on more risk since 2011 (29m31s).
• By 2021, JP Morgan Chase had grown to have $4 trillion in assets, $2.5 trillion in deposits, and $1 trillion in loans, with a significant portion of its assets being trading operations and off-balance-sheet commitments (30m0s).
• The bank's growth and increased risk-taking have occurred despite claims that it is no longer "too big to fail" (29m53s).

The Silicon Valley Bank Crisis and Federal Reserve Response

• The Federal Reserve and FDIC responded to the Silicon Valley Bank crisis by announcing that all depositors would be protected, with no losses to taxpayers, but the FDIC ultimately lost $2 billion, which will be recouped by charging other banks (30m51s).
• The Federal Reserve also announced that it would make loans to all banks, overvaluing their collateral, in an effort to prevent further bank failures (31m38s).
• The term "bailouts" is often avoided, with the Federal Reserve (FED) instead lending money to banks to pretend they didn't lose, similar to lending someone a million dollars when their house is only worth $800,000 (31m56s).
• Jamie Dimon's JP Morgan Chase is doing well after buying First Republic, highlighting the benefits of being a major bank (32m16s).

Credit Suisse and the Concept of Capital

• A course on power in finance assigned students to analyze Credit Suisse, which was described as a "zombie" bank, and predict whether it would be allowed to fail; it was eventually bailed out by the Swiss National Bank (SNB) (32m24s).
• The concept of "capital" in banking is often misused, with banks confusing equity (a rainy day fund) with cash reserves, which is a false equivalence (33m22s).
• Lobbyists argue that requiring banks to hold more capital (equity) would reduce lending and harm the economy, but this claim is disputed, with some arguing that equity is invested in the economy, not held in a cash reserve (33m50s).
• Paul Volcker stated that banks will claim any proposed regulation will restrict credit and harm the economy, which is a common tactic used by the banking lobby (34m32s).
• A collection of 44 flawed claims made by the banking lobby, along with debunking arguments, has been published online and updated over the past 11 years (35m6s).

The Banking Lobby and its Influence

• The banking lobby is considered one of the most powerful in Capitol Hill, and their influence can be seen in the politics surrounding financial regulation (35m30s).
• The banking industry's influence on law and regulation is a continuous process, with banks lobbying for laws and then trying to undo parts of them, making it a "never-ending game" (36m6s).
• In 2014, a piece of the law was passed that prohibited banks from doing all derivative trading on the same balance sheet as the deposit-taking institution, but banks like City Group tried to undo this part of the law (36m14s).
• City Group wrote a piece of legislation that was hidden in a must-pass bill, which was not discussed, and Jamie Dimon called policymakers to vote for it without discussion (36m53s).
• The banking industry uses tricks to get what they want, and policymakers often ignore the risks associated with banks because they seem like a source of funding (37m12s).
• Banks are considered national champions and are bailed out by central banks, which creates confusion and allows them to get away with things (37m38s).

Efforts for Reform and Ongoing Challenges

• The battle against the banking industry's influence started in 2010, and it has been a continuous effort to raise awareness and push for change (37m48s).
• The author has written op-eds and given testimony in Congress to highlight the issues with the banking industry and the need for reform (38m10s).
• Despite efforts to reform the banking industry, the nonsense continues, and bad rules persist, making it a "hopeless battle" (38m21s).
• The banking industry has many enablers, including academics, who benefit from the status quo and do not speak up against it (38m48s).

The Cassie Cooperation Society Initiative

• The author has an initiative at the business school called the Cassie Cooperation Society Initiative, which aims to promote trustworthy institutions and a better understanding of the role of government and business in the world (39m19s).
• The debate about capitalism and government often presents false choices, such as socialism versus market capitalism, but what's really going on is confusion, as there are no markets without rules, and these rules must come from somewhere, such as contracts or government, in order to have functioning markets (39m30s).
• The forces of capitalism have undermined and overwhelmed democratic institutions, leading to issues with free speech and propaganda from both the private sector and government (40m21s).
• The public discourse has become nonsensical, as discussed in the book "Amusing Ourselves to Death," and in order to fix capitalism, truth needs to be empowered to reduce deception in the private sector and government (41m1s).

Derivatives and Financial Opacity

• To combat the opacity of financial practices, it's necessary to address the difficulty of capturing derivative risk in financial disclosures, which may require more regulation, education, or both (41m50s).
• Derivatives are complex financial instruments, such as side bets or contracts, that can be difficult to capture in balance sheets and income statements, and pose significant risks to entities with large notional values of derivatives (42m50s).
• The incomprehension of derivative risk is a significant issue, as highlighted by a paper titled "Too Big to Depict," which refers to the challenges of understanding and disclosing the risks associated with derivatives (42m25s).
• Education and awareness of the complexities of derivatives and financial disclosures are crucial in addressing the opacity of financial practices (42m10s).
• The Office of the Comptroller of the Currency (OCC) in the US provides quarterly disclosures on derivatives, and data on this topic is also available from institutions such as the Dutch National Bank in Amsterdam (43m35s).
• Regulators must capture the risk associated with derivatives, particularly when conducting stress testing, as the current system makes it difficult to understand exposure to large banks' derivative trading (43m58s).

Regulatory Challenges and Systemic Fragility

• The FDIC is not in a position to ensure the $8 trillion in deposits at JP Morgan Chase, but the Federal Reserve's implicit guarantee prevents the bank from defaulting, allowing the FDIC to manage the risk (44m25s).
• JP Morgan Chase has a large number of open contracts, with a reported 1 million contracts against different counterparties, making it challenging to figure out the fragility of the individual bank or the system as a whole (44m45s).
• The risk associated with derivatives is dynamic and can move quickly, making it essential for regulators to pay attention to this issue and find ways to capture the risk (45m20s).

Regulatory Arbitrage and the Non-Bank Sector

• The argument that regulating banks will cause risk-taking to move to the non-bank sector is a concern, but it is essential to address regulatory arbitrage and ensure that regulations are effective in reducing risk (45m52s).
• The source of profit in the financial sector can come from beneficial innovation, regulatory arbitrage, or misconduct, and it is crucial to distinguish between these sources to ensure that regulations are effective (46m24s).
• The growth of shadow banking and non-bank lending institutions can be a concern, but some studies suggest that these institutions may be less fragile than traditional banks due to their higher equity levels and market funding (47m15s).
• The main issue with banks is that they are not making loans, but rather gambling with cheap funding, and their "too big to fail" status remains a problem, as it creates an uneven playing field and puts smaller banks at a disadvantage (47m44s).
• The speaker believes that regulation should be tailored to the level of risk, and that deposit-taking institutions should be regulated because they have access to central banks and are given enormous privileges (48m8s).
• Shadow banks are often connected to the banking system, and some of them are not a major concern, but others are, particularly those that are funded by banks and engage in regulatory arbitrage (48m31s).
• During the financial crisis, banks created special purpose vehicles to securitize mortgages, which were then sold to investors, often with implicit guarantees from the banks, and these vehicles were often connected to the banking system (48m54s).
• An example of this is City Group, which had $40 billion in commitments to securitization vehicles off its balance sheet, which would have put a huge hole in the FDIC's deposit insurance fund if the bank had failed (49m51s).
• City Group was bailed out three times, including a special bailout, and its market value was half its book value during the financial crisis, making it a symbol of bailout in the US (50m31s).
• To solve the problem of shadow banking, it is necessary to regulate the banks first and foremost, and then follow the money into the shadow banking system and regulate as needed (51m19s).

Engaging Students and Colleagues

• Students who are going into finance are often not aware of these issues, and the speaker is curious about how they react to this information, particularly those who are pursuing careers in finance and are not interested in becoming entrepreneurs (51m31s).
• The financial sector has many issues, and the main complaints are directed towards regulators, academics, and those who enable the problems, rather than the students who go into finance (51m57s).
• The speaker's courses are now listed as interdisciplinary and are not part of the finance department, but rather the Graduate School of Business (GSB), and have students who go in and out of finance as Cassie leaders (52m23s).
• The initiative is student-powered due to limited resources, and student volunteers are crucial in filling events with thoughtful people (52m36s).
• The speaker has become more attached to the students and feels that the faculty are not engaging, which is something they express openly (52m45s).
• Students who take the speaker's courses tend to understand more about the issues in finance, and even in other courses, such as real estate, they can gain a different perspective if the speaker's colleagues include issues around society and politics (52m57s).
• The speaker encourages colleagues to include issues around society and politics in their courses and not be afraid to do so (53m14s).

Contact Information

• The speaker can be contacted at adti@stanford.edu for further discussion (53m32s).