The myths that fuel the megabanks
A former Federal Reserve Bank president and FDIC vice chairman reflects.
The second edition of The Bankers’ New Clothes confirms Anat Admati and Martin Hellwig’s skepticism that rules put in place after the great financial crisis would somehow assure financial stability and end bailouts of the “too big to fail” banks. The book is written for the public, who suffer the consequences and who inevitably must pick up the tab when these banks fail. As such, it is direct in its message and clear in its discourse. It explains the foundations of banking and the role of capital in safeguarding bank depositors while exposing the myths that the largest banks use to protect their special status. The authors note, importantly, that so long as the myths fail to be challenged, these banks will continue to operate within a privileged framework.
One of the most damaging myths the authors debunk is the idea that capital as a source of funds in banking stifles bank lending and economic growth. What bankers call “capital” is simply money raised from equity investors — shareholders — and not, as banks would often have you believe, money that must be “set aside” without being used. The banks’ argument would have you believe that in contrast to any other corporation in America, banks can only remain successful if they are permitted to fund themselves with a mere fraction of the capital required by highly successful companies such as Apple, Google, or Amazon. These companies fund their activities with hundreds of billions of dollars in investor funds and little debt. In contrast, the largest banks fund their operations and assets with as little as 7 percent investor money and 93 percent in debt — funds borrowed from depositors and others. Within the financial sector, even unregulated hedge funds are better capitalized than the nation’s largest banks. Banks insist that despite obvious facts to the contrary, they are strongly capitalized. They contend that while relying on investor capital would make them stronger financially, it somehow would curtail their lending, investment, and payment services activities. As the authors document, such dire predictions are supported by nothing but the mythology that these banks have created for themselves.
As a president of a Federal Reserve Bank, preceding the Great Financial Crisis of 2008, I was repeatedly told by those in the banking industry that requiring banks to rely on investor capital would deprive small businesses and individuals of much-needed loans necessary to grow their businesses. These arguments carried the day, as many of the very largest banks in the country were allowed to fund themselves with as little as 3 percent of investor money for every dollar of assets on their balance sheets. When the crisis erupted, bank losses at many of these banks far exceeded investor capital, leading to their failure and a near-collapse of the industry. Meanwhile, the low-capital approach hardly left those small businesses and individuals better off: Loan volume declined most among the largest, less well-capitalized banks. In the end, taxpayers were required to bail out the industry with injections of new capital, and the U.S. financial system entered the age of too-big-to-fail.
Silicon Valley Bank and Signature Bank in the United States and Credit Suisse Bank in Europe all failed last year amid questions of solvency, which led to panic, a liquidity crisis, and a government-arranged bailout of depositors.
Complementing the largest banks’ myth that capital is the enemy of economic growth is the myth that bank crises are all about liquidity, when creditors (in many cases, depositors) want their money more quickly than banks can convert assets to cash. According to this narrative, the problem in times of crisis is not that the banks are fundamentally weak — in other words, insolvent — but that a panicked “run” is driving them into ruin. What is particularly disturbing is that some regulators and academics have bought into this story. However, the authors demonstrate, overwhelmingly, that liquidity problems emerge when creditors become uncertain of bank solvency. When banks fund themselves with too little investor capital and too much debt, should significant bank losses be announced, depositors can quickly become uncertain about a bank’s solvency. It is this doubt in the underlying business that leads to panic and a stampede for the door. This truth was confirmed with the 2023 failures of Silicon Valley Bank and Signature Bank in the United States and Credit Suisse Bank in Europe; all failed amid questions of solvency, which led to panic, a liquidity crisis, and a government-arranged bailout of depositors. What we learn from the Great Financial Crisis and again with the bank failures of last year is that we remain trapped in the logic of too-big-to-fail and that the myth that capital harms economic growth is just that, a myth.
Despite these realities, some still assert that too-big-to-fail is a thing of the past. This is the myth that accompanied the Dodd-Frank Act of 2010 and its promotion by both the largest banks and their regulators, and that has done enormous damage to the U.S. financial system. The authors systematically expose its absurdity in the chapter entitled “Bailouts Forever.” Dodd-Frank promised to provide regulators with tools needed to resolve large, failed banks without disrupting the financial system or economy. Large banks are required to submit plans, so-called “living wills,” to regulators showing how they would give notice of their pending insolvency and how they would work with the regulators to resolve themselves in an orderly manner. Most plans rely on what’s called a “single point of entry” approach to resolution in which a corporate owner of the bank, called a holding company, holds large amounts of debt that converts to equity at failure, thus enabling the operating bank and other subsidiaries to continue business with minimal disruption. As the authors document, history has shown that this is just another myth used to avoid having to build strength through genuine investor equity. Since Dodd-Frank, there have been significant bank failures, but no living wills have been executed and the use of bailouts to avoid financial crises continues to this day.
If funding comes from equity and not debt, the likelihood of the bank failing in the first place is reduced, as the solvency doubts that trigger runs would be eased.
A final myth the regulators would have the public believe is that adding more debt to a banking firm’s capital structure somehow improves bank resiliency and facilitates bank resolution. According to this mythology, if banks fund themselves with significant long-term debt, in the event of failure the losses are first absorbed by the creditors rather than the Federal Deposit Insurance Corporation, which insures depositors. The authors wisely expose these fallacious statements. As they explain, the addition of debt to fund a banking firm only adds to its vulnerability. Interest on debt must be paid and failure to do so places the bank in default, accelerating failure. However, the authors point that if instead of debt the bank held an equivalent amount of equity and missed a dividend payment, there would be no default. Most importantly, if the funding comes from equity and not debt, the likelihood of the bank failing in the first place is reduced, as the solvency doubts that trigger runs would be eased. Moreover, in the event of a failure, the equity would provide the FDIC with the same protection as debt from losses that follow failure.
In the final chapter, the authors ask, “Are these banks above the law?” As the mythology around the largest banks has come to be perceived as reality, their power has grown and so has their ability to operate above the law. The authors note, for example, how pervasive fraud had become in mortgage lending and securitization marketing before the Great Financial Crisis. They document how some banks falsified reports to other firms publishing indices for interest rates and exchange rates, and a host of other questionable acts. And where guilt was assigned, it resulted in only a monetary fine, which the banks came to regard simply as a cost of doing business. The authors are struck by how readily risk officers within the largest banks were neutered in the job of identifying and stopping abusive and sometime illegal actions. And because of these banks’ power, supervisory authorities stood by while violations of rules and law occurred. The authors seem to shake their head in disbelief that in most countries no high-level executives faced charges or were held responsible for their bank’s questionable actions. In contrast to what you think would occur after so many instances of abuse, the banking institutions and their executives are more wealthy and more powerful, and increasingly seem above the rules that are supposed to govern their conduct.
By updating their findings with events of the last decade, Admati and Hellwig have refocused public attention on the mythical stories told by bankers and their regulators that fail to protect the public and instead mislead it while shielding the industry from accountability.
Thomas Hoenig is a Distinguished Senior Fellow at the Mercatus Center at George Mason University. He was Vice Chairman of the Federal Deposit Insurance Corporation from 2012 until 2018. Before that, he served as President and Chief Executive Officer of the Federal Reserve Bank of Kansas City and a member of the Federal Reserve System's Federal Open Market Committee from 1991 to 2011. (Twitter: @tom_hoenig)
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
Giving power to truth - by Colleen P. Eren
It's time to challenge Wall Street from the supply side - by David Dagan
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