The Blind Eye of Admati & Hellwig

Why Admati and Hellwig's book, "Banker's new Clothes" is simply wrong. The piftfalls of obtaining more bank capital.

I enjoyed reading the book by Admati & Hellwig on the myths surrounding reform in the Banking sector. Everything in the book is true and factually correct, but the book is incomplete, leading the authors to arrive at a conclusion that is unsustainable under closer inspection. Their main conclusion, and policy advice, is that in order to make banks safe, they must hold 20% to 30% of their unweighted balance sheet total in equity. And the balance sheet total should include all derivatives at market value. The 20% should be the minimum number in times of economic recession and up to 30% in good times. Superficially, and from a micro-perspective, this makes a lot of sense, more equity indeed makes the likelihood of bank failure significantly smaller, but is it achievable? What would it take to implement these high levels of equity? Let’s take the macro perspective.
Total new equity to be raised would be equivalent to 40 to 72 percent of Eurozone GDP
In the Eurozone, according to figures compiled by the ECB, the balance sheet total of all banks is 32.000 billion euro. Total Equity and Reserves is 2.400 billion euro or 7,5% of the balance sheet total. To arrive at 20% equity, total new capital to be raised is 4.000 billion euro, to arrive at 30%, we need an extra 7.200 billion euro. Let’s try to put that in perspective.  Total new equity to be raised is therefore equivalent to 40% to 72% of Eurozone GDP. The current market capitalization of all listed companies in the Eurozone is now 42% of GDP. Of the total market cap of all listed companies in the Eurozone,  banks account for roughly 10%, so the total current market cap of banks is equivalent to approximately 4% of GDP. Implementing the requirement would entail a shift in the asset allocation by investors of seismic proportions. The capital markets are simply nowhere near big or deep enough to accommodate such an expansion of equity. IPO’s and secondary offerings have rarely exceeded the 20 billion mark, so raising 7000 billion is undoable in any reasonable time frame.

Debt-to-equity conversion

And where would the money come from? It could come from the deposits of the private sector, currently at 11.000 billion euro, but that would mean an enormous shift in preference at households and corporates, from liquid, mostly near risk free assets to bank shares. Unlikely to happen, to say the least. Or it could come from the voluntary conversion of outstanding bank bonds into equity. Total bank bonds outstanding is now 4.500 billion euro, so theoretically we could come a long way down that route, but it would require institutional investors to radically overhaul their asset allocations. And since most of those investors are insurance companies, pension funds and other banks, that would first require a lowering of the risk weights and capital requirements assigned to bank equity by legislators and regulators. That would mean higher risks at insurance companies and pension funds in exchange for safer banks. Not going to happen.

Retaining profits

Well, say Admati & Hellwig, perhaps raising equity through the stock  market is impossible for some banks, then they should simply retain all profits and stop all dividend payments. Good point. Let’s take the macro view again. Before the crisis, Return on Equity at banks in the Eurozone stood at 14%. Today it’s a small 5% to negative, and very few expect ROE to return to pre-crisis levels. Most observers expect ROE to stabilize between 8% to 12%. Let’s suppose an even 10%. That’s 250 billion in after tax profits. To reach the required minimum of 4.000 billion euros would take 16 years of perfect performance by all banks and economies without  a single hiccup. 29 years to reach the required 30% in equity. To some, such a timeframe may seem acceptable but it is not. During the period of equity build up, banks will be very, very restrained in balance sheet growth. After all, every euro in extra loans requires 30 cents in extra equity, pushing the required threshold of 30% further back in time. In nominal terms, banks will likely  be more or less stable over the period, but in real terms, banks will shrink, and retaining profits without growing the loan book will shrink the money supply as we move along. With a stable balance sheet, bank banks can only grow profits by expanding the interest margin. (and efficiency of course, but the impact will be very limited as much of the cost base will rise with inflation). So, 16 or 29 years hence, one of two things will have happened, either bank profits remain at 250 billion, leading to an ROE at that time of roughly 2,5%, which is likely unacceptable to investors. Such a bank will trade at a large discount to book value, and a smart investor will buy the bank, sell all the assets, and take the capital elsewhere.  Or, a much more likely scenario, credit will become a lot more expensive than it is today to increase interest margins at banks. Not a positive for economic growth.


An equity requirement of 20% to 30% is therefore unachievable. Indeed, the Emperor may be naked at times, but in the land of the blind, One-Eye is apparently King. As is often the case in economics, what seems irrefutable in the micro-model, totally fails at the macro level. And so a new myth about gets spread, the myth that it’s ‘easy’ to raise equity requirements. Yes, we do need to fix Too Big Too Fail and end all the distortions of implicit and explicit subsidies. Higher capital requirements are indeed needed, but the only achievable route of sufficient size is bail-in capital. Exactly the route the Eurozone has taken.  As of 2018, all bank liabilities with the exception of deposits below euro 100.000, will become bail-innable under the newly proposed rules. The rejection of bail-in capital by Admati & Hellwig is perhaps their biggest oversight. However, we mustn’t forget that the true risk of banking is on the asset side of banks. The liability side determines only the funding and spreading of risk, the asset side determines the size and nature of the risk. Caps on credit growth, and minimum standards of credit quality for non-productive assets remain of the utmost importance, regardless of how much risk bearing capital one throws at it.