Journal of Economic Literature 2014, 52(1), 197–210
http://dx.doi.org/10.1257/jel.52.1.197
197
1. Introduction: A Book Worth Comparing
to Keynes’s
General Theory
W
e expected that the Great Recession
after 2007 would yield major written
responses that should be worthy of such
global attention as Keynes’s General Theory
received in 1936. The Banker’ New Clothes:
What’s Wrong with Banking and What to Do
about It by Anat Admati and Martin Hellwig
is such a book. Admati and Hellwig have
written a book for the general public about
fundamental problems of financial instabil-
ity in our time. They have used their com-
mand of economic theory to identify one
*
University of Chicago. The author is greatly indebted
to Jeremy Bulow, John Cochrane, Milton Harris, and
Douglas Levene for detailed comments that substantially
improved this paper.
†
Go to http://dx.doi.org/10.1257/jel.52.1.197 to visit the
article page and view author disclosure statement(s).
key central issue that informed citizens need
to understand: banks should be required to
have much more equity.
Banks are vital financial institutions that
channel millions of people’s savings into
credit for economic investments. In particu-
lar, banks get substantial funds from depos-
its which, as debts of a bank, are supposed to
have such a clear and safe value that everyone
should accept them as equivalent to any form
of cash. Such power over the investment of
other people’s money can entail regular temp-
tations to abuse the depositors’ trust, however.
Small businesses and other borrowers who
rely on banks for credit implicitly depend on
bankers’ ability to maintain depositors’ trust,
but small depositors cannot be expected to do
all the necessary work of monitoring to certify
that their banks are trustworthy. So there is an
essential role for public regulation of banks:
to maintain stable trust in channels of credit
that are vital to our society.
Rethinking the Principles of Bank
Regulation: A Review of Admati and
Hellwig’s The Bankers’ New Clothes
†
Roger B. Myerson*
In an important new book, Anat Admati and Martin Hellwig raise broad critical
questions about bank regulation. These questions are reviewed and discussed here,
with a focus on how the problems of maintaining a stable financial system depend on
fundamental problems of information and incentives in financial intermediation. It is
argued that financial regulatory reforms can be reliably effective only when their basic
principles are understood by informed citizens, and that Admati and Hellwig’s book
is a major contribution toward this goal, as it clearly lays out the essential case for
requiring banks to have more equity. (JEL G01, G21, G28, G32, L51, M48)
Journal of Economic Literature, Vol. LII (March 2014)
198
But the vast wealth involved in the bank-
ing business is more than enough to poten-
tially corrupt any small group of officials, so
the reliability of any regulatory system must
depend on broad public monitoring of the
regulatory process itself. Regulators’ rulings
must be based on public information accord-
ing to principles that informed citizens can
understand, so that public officials can be
held accountable for any failure to regulate
appropriately, even when a major crash does
not result from this failure.
Thus, any meaningful financial regulatory
reform must include a clear explanation of
its principles to millions of informed citizens
and investors. Admati and Hellwig’s new
book can fill that essential role. Other excel-
lent books should also be recommended
(see Goodhart 2009; Dewatripont, Rochet,
and Tirole 2010; Schooner and Taylor 2010;
Kotlikoff 2010; Duffie 2011; Barth, Caprio,
and Levine 2012; and Gorton 2012), but
Admati and Hellwig have matched broad
clarity of exposition with a carefully cho-
sen focus that deserves the widest public
readership.
2. Why Banks Should Be Required to
Have More Equity
The core message in this book is that banks
should be required to have more equity. A
bank’s equity is its owners’ stake in the bank’s
investments. This equity value also called the
bank’s capital. The value of this equity can
be computed by adding up the values of all
the assets or investments that the bank owns,
then subtracting the values of all the debt
liabilities that the bank owes to its depositors
and other creditors. The difference is the
value of the equity or capital that belongs to
the bank’s owners.
Admati and Hellwig introduce these ideas
with a story about a person named Kate
who is buying a house, partly with her own
money and partly with money borrowed in
a mortgage. The part that Kate bought with
her own money is her equity or capital in
the house. For a house of any given current
value, if Kate put more of her own capital
into the purchase price, then the mortgage
lenders would bear less risk of the house’s
value falling below the amount owed in a
default, and so they should be willing to lend
to Kate at a lower interest rate. In such a sit-
uation, Kate may well feel that contributing
more capital could actually make her house
investment less expensive. But when Kate’s
rich Aunt Claire offers to sign a loan guaran-
tee, suddenly Kate can get a low interest rate
on the mortgage loan that will not depend on
the amount borrowed. Then Kate may begin
to see equity as an expensive way to finance
her house, and she may have an incentive
to borrow as much as she can, investing her
own money elsewhere. But borrowing more
is implicitly transferring more risks to Aunt
Claire, who must pay the guaranteed amount
if the house’s value falls and Kate defaults on
the loan. So Aunt Claire should not sign a
loan guarantee without specifying some
lower bound on how much Kate has to con-
tribute to the price of the house. This is the
basic logic of equity regulation, except that
Kate becomes a bank owner and Aunt Claire
becomes the taxpaying public.
Admati and Hellwig report that, early
in the twentieth century, banks typically
had equity capital worth about 25 percent
of their total assets. That is, each dollar
invested by such banks included twenty-five
cents that actually belonged to the bank’s
owners, along with 75 cents borrowed from
depositors and other creditors. If the value of
the bank’s assets were to decline, the losses
would be borne by the owners, with no affect
on the bank’s ability to repay its depositors,
until the owner’s equity was exhausted. So,
a large value of equity was needed to reas-
sure depositors that the bank was very likely
to be able to repay them. Without this reas-
surance, they would not have been willing to