Giving power to truth

The vexing political economy of capital requirements

There have been abundant postmortems of the financial crisis of 2008 written for a well-informed but popular audience by authors from academia, journalism, and government over the past 16 years. These attempts to demystify for the public an otherwise enormously complicated financial landscape include Andrew Ross Sorkin’s Too Big To Fail, Bethany McLean and Joseph Nocera’s All the Devils are Here: The Hidden History of the Financial Crisis, former Federal Reserve Vice Chairman Alan Blinder’s After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead, Martin Wolf’s The Shifts and the Shocks: What We’ve Learned, and Still Have to Learn from the Financial Crisis, former U.K. Financial Services Authority Chairman Adair Turner’s Between Debt and the Devil: Money, Credit, and Fixing Global Finance, and Neil Fligstein’s The Banks Did It: An Anatomy of the Financial Crisis, and the government’s own post-mortem, the Report of the Financial Crisis Inquiry Commission. These works are not merely descriptive, but as can be gleaned even from a cursory look at the titles, have sought to prescriptively affect policy and prevent the next disaster. These books have something else in common, too: They all refuse to isolate the causes of the crisis to a single variable, instead implicating a range of structural, psychological, historical, sociopolitical, and economic factors.

Among these authoritative accounts of the 2008 crisis focused on making system-wide flaws in banking legible for the public and, accordingly, propelling change in that sector, was the ambitious The Banker’s New Clothes: What’s Wrong With Banking and What to Do About It, by Anat Admati, a professor of finance and economics at Stanford, and Martin Hellwig, director emeritus at the Max Planck Institute for Research on Collective Goods. In the first edition of the book, while acknowledging other precipitating factors, they homed in almost exclusively on the enormous, systemic risks borne by society when banks have less than 10 percent, and more often 5 percent or less, in equity relative to total assets — in other words, when they simply have too much debt. The 2013 book persuasively argued that this reality was a primary cause of the crisis, and that permitting it to continue all but guarantees the next disaster.

First, it asserts that bankers, and the politicians and academics who shill for that industry, have deliberately made spurious claims, such as obfuscating the difference between cash reserves (held by the bank and not loaned out) and capital (unborrowed funds from shareholders or owners that can be loaned out). They did so by claiming that to increase equity would spell disaster for the business and household lending necessary for a robust economy.

Second, Admati and Hellwig explained that while increasing reserve requirements indeed would have tradeoffs, lending does not have to be reduced with more usage of unborrowed funds — unless banks are using borrowed funds to make unreasonable loans, which investors would scrutinize more closely if they had more skin in the game. There are no downstream negative societal ramifications, they claimed, but to the contrary, the stability and “health” of the financial system would increase. The oft-repeated claim that “equity is expensive,” for them, is a myth—a form of the emperor’s new clothes. Last, they argued that to inoculate the economy against future crises, banks should mirror other firms and corporations that do not borrow at all, or have a healthy amount of equity. Their recommendation was for equity in the 20-30 percent range — a far cry from the “Basel III” rules that global regulators negotiated in the wake of the crisis, which de facto still permit equity-to-debt ratios as low as 3 percent.

Admati and Hellwig’s perspective is reminiscent of the Gramscian idea of cultural hegemony, whereby the ability to mold discourse and false narratives to achieve support for the status quo is a kind of ideational, soft-power control exerted by the ruling class.

In the 2024 edition, Admati and Hellwig have updated the book with an additional four chapters under the heading “Undermining Democracy and the Rule of Law.” Providing recent examples of the system’s ongoing fragility, from Silicon Valley Bank to Credit Suisse, they zoom out to give a critical analysis of the political economy of banking and why in the 16 years that have elapsed, equity requirements have not been adequately revised. They point to myriad factors to explain the persistence of systemic financial risk: the army of professional banking lobbyists intent on light-touch regulation; reliance on corporations to enforce regulations internally; the political heft of CEOs like JP Morgan Chase’s Jamie Dimon; the incestuousness of the revolving door between regulators and for-profit industry; the moral hazard of bailouts to both institutions and individual investors provided by activist central banks; faulty accounting rules that deliberately underestimate risk; massive amounts of fraudulent behavior like that witnessed in the LIBOR interest-rate manipulation; a nationalistic impulse by governments and regulators to shield “their” banks in order to be competitive on the global stage; capture of auditors and ratings agencies that are paid by the very industry they are assessing, and a tax code that subsidizes borrowing rather than ownership, among others.

These concluding chapters lean heavily into a critical perspective of political economy predicated on class divisions. The banking industry, comprised of a politically connected upper class, consolidates power to obtain more wealth without risk, positions itself outside of democratic constraints, and enshrines financial and legal privileges for “the few.” Admati and Hellwig’s perspective is reminiscent of the Gramscian idea of cultural hegemony, whereby the ability to mold discourse and false narratives to achieve manufactured consensus and support for the status quo is a kind of ideational, soft-power control exerted by the ruling class. For example, in the final few paragraphs, they reiterate the book’s central metaphor of the emperor’s new clothes, and how bankers’ mythic and deceptive narratives “divert attention [of the masses] away from deeper issues.” Elsewhere, they invoke cultural critic Neil Postman’s 1985 observation that “our public discourse has become dangerous nonsense.” They write that one of the two primary ways in which conditions of political equality are being eroded is through “power [which] dominates communication and determines narratives influencing legislation and jurisdiction.”

But the 2024 edition begs the question of how the earlier, meticulously laid out, supremely rational arguments for more equity-to-debt in banks can ever break through the morass of institutional realities and entrenched class interests depicted in the new chapters. The book’s ambition all along has been to provide the public with clear, transparent knowledge of falsehoods about equity, among other banking sector concerns. The obvious speculation left for the reader to ponder is whether, if more people were to recognize the massive costs we are all bearing under the present system, they would become outraged and participate in the political process to reverse course.

While I do not wish to offer an entirely pessimistic counterargument, I would suggest two socio-political realities that militate against this “accurate-knowledge-of-how-bankers-are-fleecing-Americans-leads-to-awakened-class-consciousness-leads-to-political-advocacy-leads-to-effective-regulations” theory of change for banking in the U.S.

The first reality is that what is truth, e.g., that which is not the emperor’s new clothes, is complicated. The U.S. government has been implicated heavily in many of the institutional changes in banking that led to the crisis. And, importantly, it has done so not out of some kind of nefarious plan to ensconce an aristocracy and immiserate the masses, but to the contrary, to expand the vaunted American dream of a middle-class lifestyle to a larger subset of the populace—without increasing government debt. To borrow terminology from Neil Fligstein, the government has been “codependent” on the banking sector for its progressive social initiatives. The government over the 20^th century incentivized home purchases through legislation that expanded the pool of mortgage applicants by liberalizing down payment requirements and thus made mortgages riskier. In the same way that debt is subsidized for banks, as Admati and Hellwig note, so too is debt subsidized for homeowners by the tax codes that allow for home mortgage interest deductions, which impacts two-thirds of Americans. The development of the mortgage-backed securities and government-sponsored entities so integral to the financial crisis came from the Johnson administration and Democrats, who thought that savings and loan banks were insufficient to get Boomers and lower-income people into homes (but still wanted mortgages off their balance sheets). Admati and Hellwig themselves cite a study that found Fannie Mae and Freddie Mac improved the terms under which a full two-thirds of home buyers could borrow. These government-sponsored entities were then pivotal in the mortgage securitization market that allowed for such access to mortgages for more Americans. Further examples include the deregulatory initiatives and lowering of capital requirements that took place during the savings and loan crisis, which were enacted because of the importance of the S&L industry to home mortgages for average Americans. And in 2024, members of the Congressional Black Caucus and other Democratic lawmakers, affordable housing advocates, and civil rights groups are opposing a Fed plan to increase bank capital requirements. Why? Because they want the “social good” of expanded home ownership for low-income and minority borrowers who are higher risk, and who big banks like JP Morgan have been targeting for housing equity programs.

The enmeshing of government’s social initiatives with the banking industry’s rent-seeking does not negate Admati and Hellwig’s argument that the banks should increase their equity, or that this lack of equity creates instability and shared risk across the economic system. However, it does complicate the story of greedy bankers running amok with a one-way accrual of benefits. It points to an interest convergence that has had benefits and incentives for working and middle-class Americans who otherwise would not have been able to access mortgages on more stringent terms, and who have benefitted from the liberalization, with all its risks. A similar argument can be made about cheap access to credit for lower- and middle-class Americans offered by banks. Certainly, it benefits banks to charge exorbitant rates, and consumers’ payment of high interest rates on held monthly balances gets them locked into cycles of debt that, in the aggregate, harm the economy. Yet, credit allows for continued consumption and attainment of the markers of a middle-class lifestyle. It has been countered that to the extent lax equity requirements promote these goals, there are much more efficient and less-risky ways to go about it, such as direct subsidies. But as Niskanen Center Senior Fellow Monica Prasad has argued, over the decades, “Financialization became the political path of least resistance for addressing citizens’ social needs.”

The complex, sometimes predatory, but often symbiotic interplay among the U.S. banking sector, government institutions, and voters makes even the most reasonable, convincing proposals for less debt and more equity in banking remarkably thorny political projects.

The second argument that cuts against the accurate knowledge→awakened class consciousness→political action theory is that, while Admati and Hellwig denounce the idea of a class society where those not on the top are powerless to defend themselves, what they do not provide is a sense of the constituency that actually would vote on the basis of, lobby for, and unite against these policies. Should this be a working-class movement? A middle-class movement? An all-but-the-titans-of finance-movement? And the rise of a movement itself assumes some well-organized amplifying mechanism for unbiased, “accurate” information about bank equity (other than through well-intentioned academics and journalists writing for a college-educated audience with an active interest in the topic, a decidedly small sliver of the population). This theory of political action takes for granted an effective, loosely class-based political mobilization that is far from guaranteed based on truthful knowledge of the dangers of too much debt in the banking sector alone — a topic that is complex, and, let’s be honest, boring in comparison to the red meat of other issues. Given all the other political topics consuming public attention such mobilization appears unlikely — especially during periods of non-crisis. To cite the adage by William Cobbett, “I defy you to agitate a fellow with a full stomach.”

Even in the immediate aftermath of the financial crisis, when the U.S. lost 3.6 million jobs, and 3.3 trillion in home equity was erased, but the banks were bailed out, what emerged from the acute discontent at that bailout were mobilizations from both right and left that were unfocused on making the kind of policy changes necessary to increase bank equity. The left-leaning Occupy movement of 2011 took malfeasance in banking and failure to hold banks accountable as a central focus, with signs stating, “Hungry? Eat a banker” or “Eat the rich” and “We are the 99 percent” gesturing towards an energized class-based politics. However, Occupy has been abundantly criticized for its failure to articulate concrete goals (never mind something as laser-focused as 30 percent equity-to-assets), dearth of strategic planning, and over-inclusiveness in defining its constituency. “The 99 percent” may have been a viral phrase that impacted culture, but the fact that most Occupy participants were college students or college-educated, and therefore in the long term most likely to be the winners (in spite of student debt) in the American economy, illustrates that it was not, in fact, a movement of the 99 percent. It fizzled without making a dent in the problems of banking articulated so well by Admati and Hellwig.

On the right, the Tea Party movement that formed also after 2009 likewise showed how even in times of outrage over corporate bailouts, channeling that discontent into tackling systematically the problems of banking seems quixotic. Within the Tea Party, anger at government’s costly bailouts of banks, at government-sponsored entities that fueled the crisis, and at corporate welfare was accompanied by contempt for “bailouts'' of individual homeowners and other forms of welfare, with popular “Honk if I’m paying your mortgage” bumper stickers exemplifying this “big government” critique. These activists therefore did not adopt the vantage point of Admati and Hellwig, that the benefits from a high-risk system of banking following bailouts was solely confined to the banking “class.” They implicated members of the working and middle-class who were also rescued by taxpayer dollars. They espoused a generalized mistrust of and anger at institutions of government, leveled particularly ire at former President Obama, and promulgated a politics of nostalgic resentment. Therefore, this movement was able to be transmogrified into MAGA and Trumpism, which, in its anti-democratic fervor and support for a charismatic figure from the elite, is far removed from the more democratic outcomes advocated for in The Banker’s New Clothes. And, Trump is far from the figure to make  robust regulation of banks and equity requirements part of his platform, as seen in his 2018 “Reform Act,” even though some Trump-supporting politicians like Josh Hawley and J.D. Vance are taking on the big banks over issues like high credit card fees and bonuses for executives of failed banks.

The final sentence of the Bankers’ New Clothes reads, “We must see to it that public discourse gives more power to truth.” This is absolutely true. Yet, the two sociopolitical realities articulated above bespeak a complex, sometimes predatory, but often symbiotic interplay among the U.S. banking sector, government institutions, and U.S. voters that makes even the most eminently reasonable, convincing proposals such as that of Admati and Hellwig for less debt and more equity in banking remarkably thorny political projects. Truth in public discourse may not be enough. Discussions of what a realpolitik of these changes would look like for those concerned about the instability of the economic system are needed. In other words, we should start from the final four chapters of the book and work backwards. And, finally, the truth should also include the ways in which the instability of the system is not a fault that lies only on the shoulders of the bankers, but on those who also have taken on disproportionate risk for individual benefit or — if even only out of political expediency — for a social good.

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Colleen Eren is Associate Professor and the Criminology and Criminal Justice Program Director at William Paterson University, a senior fellow at the Niskanen Center, and a member of the Crime and Justice Research Alliance. She is author of Bernie Madoff and the Crisis: The Public Trial of Capitalism (Stanford University Press, 2017) and, most recently, Reform Nation: The First Step Act and The Movement to End Mass Incarceration (Stanford, 2023). (Twitter: @ColleenEren)

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Read more:

Can democracy take stock of Wall Street? (Editor’s note)

Capital confusion - by Anat Admati and Martin Hellwig

Bailouts forever - by Anat Admati and Martin Hellwig

The myths that fuel the megabanks - by Thomas Hoenig

It's time to challenge Wall Street from the supply side - by David Dagan