It's been almost five years since the depths of the financial crisis, and we're still feeling its aftereffects today. Unemployment in the U.S. remains far too high, and economic growth is still unsatisfactory. Overall, the financial crisis of 2007-2009 could result in a decline of economic output of more than $13 trillion, according to the Government Accountability Office.

One might think that our political and financial leaders would be committed to doing everything in their power to prevent a similar crisis in the future. Unfortunately, that hasn't appeared to be the case so far. In The Bankers' New Clothes, Anat Admati and Martin Hellwig argue that today's banking system "is as dangerous and fragile as the system that brought us the recent crisis." They also believe that there hasn't been enough serious analysis of how the financial system could be made safer.

This sorry state of affairs should be unacceptable to all Americans. Fortunately, Admati and Hellwig provide a very clear proposal for real reform of our banking system. The Bankers' New Clothes should be required reading for our policymakers in Washington, D.C.


It's not rocket science
Admati and Hellwig's central argument is very simple. They believe that our banks rely too much on borrowing to fund their investments and that they should be required to have much higher equity levels than they currently maintain. Nowadays, debt often accounts for more than 90% of total assets for some of our larger banks. The authors, on the other hand, declare that they "have never received a coherent answer to the question of why banks should not have equity levels between 20 and 30 percent of their total assets."

Admati and Hellwig are very effective in showing precisely how borrowing magnifies risk and what excessive levels of debt means for banks. Clearly, our bankers are not unaware of what can go wrong by not having enough equity on their balance sheets. To illustrate the point, the authors quote Nobel laureate Merton Miller, who said, "I can't help smiling at complaints from bankers about their capital requirements, knowing that they have always imposed even stronger requirements on people in debt to them."

Too big to fail is an even bigger problem now
The key problem with excessive borrowing by the large Wall Street banks, of course, is that the costs are often borne by others. The authors point out that during the financial crisis, bank losses were picked up by taxpayers, creditors, and shareholders, while executives were able to keep their huge pay packages from previous years. Nowadays, the very legitimate fear of contagion ensures that our government would be reluctant to let one of our big banks fail, despite the tough talk on Sunday morning television shows. And this reluctance leads to even cheaper credit for the big banks, which in turn encourages even more borrowing. The authors believe that too-big-to-fail policies have "strong and perverse effects on banks' behavior."

The case of JPMorgan is particularly instructive. Admati and Hellwig show us that its "fortress balance sheet" is actually much more vulnerable than one might think. The company has almost $1 trillion in commitments to some business units that it doesn't include on its balance sheet, and its accounting treatment of derivatives also makes its balance sheet appear stronger than it actually is. If JP Morgan ever got into serious trouble, of course, it could have extremely serious consequences for the U.S. economy, according to the authors.

Throughout the book, Admati and Hellwig emphasize that insisting on more equity and less debt is the best and easiest solution of all. Alas, they believe that Basel III, the most recent global standard on capital adequacy, is insufficient to the task at hand. Even though Basel III is supposed to be stricter, it still permits banks to have equity that is just 3% of total assets in some instances.

Ultimately, the authors argue that equity relative to total assets needs to be increased considerably, and that this will not impose meaningful costs on society. And Admati and Hellwig firmly reject the notion that increased capital requirements will result in decreased lending - in fact, they feel strongly that that particular argument is a red herring put out there by the bankers themselves.

Too complex to understand?
If the solution is as simple as Admati and Hellwig suggest, then why haven't we adopted it by now? Here, the authors are very persuasive. They argue that Wall Street bankers have succeeded in making this topic appear to be too complicated for ordinary citizens to consider. Individuals who don't know the difference between reserve requirements and capital requirements, for example, are understandably reluctant to weigh in on the broader topic.

Reform along the lines proposed may actually be a possibility in the near future, however. The new banking bill put forward by Senators Sherrod Brown and David Vitter seems to be informed by some of the thinking expressed by Admati and Hellwig.

One of the greatest strengths of this book is that it clearly explains the issues for the ordinary reader. Financial reform shouldn't be left solely to Wall Street bankers and their captured policymakers in Washington, D.C., to decide. Regular citizens must make their voices heard, and this book will help them understand the basic terminology and concepts. I encourage everyone with an interest in effective financial reform to pick up a copy today. This just might be the most important book of 2013.

JPMorgan is one of the most talked about banks out there at the moment. To learn whether JPMorgan is a buy today, check out The Motley Fool's premium research report on the company. Click here now for instant access!

The article How to Avoid Another Catastrophic Financial Crisis originally appeared on Fool.com.

John Reeves has no position in any stocks mentioned. The Motley Fool owns shares of JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.


Increase your money and finance knowledge from home

Understanding Stock Market Indexes

What does it mean when people say "the market is up 2%"?

View Course »

Portfolio Basics

What are stocks? Learn how to start investing.

View Course »

Add a Comment

*0 / 3000 Character Maximum