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Subtitle: What's Wrong with Banking and What to Do about it - Princeton
Univ. Press, Princeton, 2013, 396 pgs., index , references (24 pages), end
notes (a full 107 pages), several figures
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Reviewer's Comment - This is a remarkable book. The authors have so
much right yet manage to ignore the central problem that led to the financial
crisis of 2007-8; namely the historic interconnection between banking systems
and government. One has to read Calomiris' and Haber's
Fragile by Design to find the very same
episodes described including with the role of government, rather, than as
Admati and Hellwig claim it was all due to bankers. Yet, they are right indeed
in their critique of the structure of bank assets and their belief that a much
larger equity component is necessary. Peter Wallison focuses on the mortgage
industry part of banking in his Hidden in Plain
Sight. Personally, I would like to see equity compose 50% of a
commercial bank's assets. But that is because I believe the entire structure of
an economy based on expanding credit is dangerous and worse. While investment
banks should be again non-limited partnerships not protected by tax payers. The
content of the book is repetitious because the author's focus on their one
issue, percent of equity in bank assets. When treating each of many component
issues they repeat their mantra. They clearly write for a very unknowledgeable
lay audience by using very homely examples. But some of their analogies stretch
the relationship too far. The entire tenor of the book is polemical and
accusatory. The crisis in the first place was due to lobby efforts of bankers
to avoid necessary regulation and the needed reforms have been prevented by
continued banker lobbying. The authors ignore right off that it is government
officials beholden to specific interest groups that set the policies. There are
many more interest groups (including bureaucrats themselves) who have major
stakes in the conduct and outcome of the financial system.
I have a list of references below.
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Preface:
The authors write: In fall 2008 the entire financial system was near collapse.
It was obvious major reform is needed. Yet no serious analysis of the causes
and therefore solutions for making the system safer has been made. Many of the
standard explanations from the establishment are false. The banking industry
has lobbied in its own interest to prevent change. Bankers, regulators, and
policy makers have ignored the fundamental risks in banking. They do not
understand fundamentals. The financial system is 'dangerous and distorted'.
"Weak regulations and ineffective enforcement were similarly instrumental
in the buildup of risks in the financial system that turned the U.S. housing
decline into a financial tsunami'. The banking system is still fragile and
requires stronger regulation and enforcement.
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Chapter 1 - The Emperors of Banking Have No Clothes -
This is a clever polemical idea. No one is willing to tell the truth about the
financial system except our authors. They write: "A major reason for the
success of banking lobbying is that banking has a certain mystique. There is a
pervasive myth that banks and banking are special and different from all other
companies and industries in the economy."
Well, they are in that they receive a charter from the government to create the
money supply. However it is true, unfortunately, that a 'shadow banking' system
composed of certain other organizations have also found ways to create money.
Nevertheless, money creation is mostly confined to government sanctioned
entities.
Our authors state that their purpose is to 'demystify banking and explain the
issues to widen the circle of participants in the debate."
Well, as I noted they do indeed provide an excellent description of banking,
except for the part about how the modern banking system was created by
governments to serve governments. For that essential fundamental one has to
read Fragile by Design and also Felix Martin's book, Money: The
Unauthorized Biography"
Another remarkable comment: "Meanwhile, politicians seem to be taken in by
the lobbying." - with examples. Do the authors believe politicians are
idiots? They write over and over, "The banking system is still much too
fragile and dangerous." Of course they are right. But they apparently
cannot recognize the real why. For example as evidence of the banker's new
clothes, they write, "Excessive borrowing by banks was identified as a
major factor in the crisis of 2007-2008 '..... "Nevertheless, the banking
industry fights aggressively against tighter restrictions on bank borrowing.
The constant refrain is that too much tightening of such restrictions would
harm economic growth." Well, of course it would in the economic system
that relies on expanded consumer consumption financed by a money supply
composed of expanding credit. The people want more, they want to spend more,
the politicians want to give them more to spend, ergo the banks have to lend
more which means they have to borrow more. The politicians speak out of both
sides of their mouths, eager to blame bankers for doing exactly what the
politicians demand. Actually the following chapters in which the authors well
describe the manner in which the banking system accomplishes this are
excellent. The authors claim such arguments are 'nonsensical and false."
They write this claim over and over. The chapter content elaborates on this
theme, that banks borrow too much and the regulations governing the ratio of
capital are inadequate. True enough, but the authors give examples of
non-banking corporations that do not recognize the fundamental function of
banks - to create the money supply - not create non-financial goods and
services.
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Chapter 2 - How Borrowing Magnifies Risk -
The authors write: "Understanding banks requires an understanding of
borrowing." Indeed it does, but with their homely examples of borrowing by
individuals and industrial companies they actually introduce confusion. Banks
borrow for a different reason and use the borrowed funds for a different
purpose than individuals using a mortgage to buy a house. The essence is that
individuals borrow to buy, but banks borrow to loan. And borrowing does not
increase the money supply, but loaning does and that is the function of banks,.
The reason for the difference is that banks can loan multiples of the number of
dollars (amount that they borrow). The authors quite correctly focus on the
fact that "Borrowing creates leverage: by borrowing, individuals and
businesses can make investments that are larger than they can afford on their
own right away." But the real leverage comes from the fact that it was the
loaner (bank or credit company) that created the money for the loan out of
nothing. The authors use an example of an individual borrowing via mortgatge to
buy a house. They have graphs and tables to show various mixes of equity and
borrowed funds and the resulting different returns or losses on equity if the
house increases or decreases in value. All excellent but not relevant to what a
bank does.
They conclude with a section ' Banks Borrow a Lot.
First, they claim that corporations do not borrow a lot. This is false. Their
example. Apple, borrows specifically in order to pay dividends without
depleating or being taxed on its capital. Overall, the size of the corporate
debt in the U.S. is huge. But that is not the falicy here. They insist that
banks today borrow too much. They note correctly that U.S. banks (which were
private) in the first half of the 19th century held capital (equity) often of
40-50 %. But they ignore that many more of these banks failed than do banks
today. Over the past 200 years holding larger precentages of equity versus debt
on their asset side by private banks has not prevented their failure when on
their liability side the loans proved to be failures
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Chapter 3 - The Dark Side of Borrowing -
The authors begin, "Debt is a promise." Indeed, as they note it can
be a heavy burden and become unfulfillable. And that is a problem today. They
continue, that most corporations limit their debts but "Banks, however,
experience the burden of debt differently from other borrowers. They see mainly
the bright side. This results in banks' borrowing significantly more than other
corporations." Of course they do, because banks (financial institutions in
general) use the borrowed funds for a fundamentally different purpose than do
industrial corporations or individuals. Again, non-financial outfits borrow to
fund creating some good or service from which their profit flows. But banks
borrow in order to lend in multiples of the quantities they borrow. For
instance, if a bank borrows a dollar at 5% interest and loans that dollar at 6%
or even 8% it will likely not show a profit after paying its own overhead. But
if it loans 10 dollars on the basis of that one dollar of capital at 6% it will
make a profit. But our authors return to the example of an individual Then they
explain well the difference between liquidity problems and insolvency.
The conclude with a great insight. "The effect described in this example
shows that borrowing is addictive in the sense that, once debt is in place,
Borrowers can become biased in favor of more borrowing and they generally
resist reducing their indebtedness." Marvelous, and who are the greatest
borrowers in the world today? Why. U.S. politicians and second greatest is the
American public led by its politicians. But our authors seem oblivious to this.
As the head of Citi commented, he had to keep dancing until the music stopped.
And the orchestra was led by Barny Frank and his cronys.
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Chapter 4 - It is Really " A Wonderful Life?" -
Finally in this chapter the authors write that they will explain what banks do.
They offer the example of banking depicted in the movie 'Its a Wonderful Life,'
to show that even small-time banking had its financial problems. They describe
well the categories on a bank balance sheet - assets and liabilities.
Now they get into the specifics they should have provided previously. " A
bank's task in lending, however, is not just to provide funding to anyone for
any purposes. Rather the bank must discriminate between loans that should be
made and loans that should not. Successful lending rerquires information and
skill, and it involves specific risks."
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Chapter 5 -Banking Dominos
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Chapter 6 - What Can Be Done?
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Chapter 7 - Is Equity Expensive
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Chapter 8 - Paid to Gamble
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Chapter 9 - Sweet Subsidies
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Chapter 10 - Must Banks Borrow So Much?
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Chapter 11 - If Not Now, When ?
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Chapter 12 - The Politics of Banking
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Chapter 13 - Other People's Money
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Peter J. Wallison - Hidden in Plain Sight - What Really
Caused the World's Worst Financial Crisis and Why it Could Happen Again
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Charles W. Calomiris and Stephen Haber - Fragile by Design: The
Political Origins of Banking Crises and Scarce Credit
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Peter Conti-Brown - The Power and Independence of the Federal
Reserve
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Stephen D. King - When the Money Runs Out
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Rana Foroohar - Makers and Takers: The Rise of Finance and The Fall
of Ameerican Business
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John Tamny - Who Needs the Fed?:
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S. Herbert Frankel - Two Philosophies of Money: The Conflict of
Trust and Authority
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G. L. S. Shackle - Epistemics and Economics: A Critique of Economic
Doctrines
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Geoffrey Ingham - The Nature of Money
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L. Randall Wray - Modern Money Theory: A Primer on Macroeconomics
for Sovereign Monetary Systems
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Geoffrey Ingham - Capitalism
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Felix Martin - Money: The Unauthorized Biography
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Glyn Davies - History of Money: From Ancient Times to the Present
Day
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Perry Mehrling - The New Lombard Street: How the Fed Became the
Dealer of Last Resort
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Philip Coggan - Paper Promises: Debt, Money and the New World
Order
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David Graeber - Debt: The First 5,000 Years
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Lawrence H. White - The Clash of Economic Ideas
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Hunter Lewis - Where Keynes Went Wrong
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Nicholas Wapshott - Keynes - Hayek: The Clash That Defined Modern
Economics
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