Friday, March 1, 2013

The banker's new clothes -- review

I wrote a review of Anat Admati and Martin Hellwig's nice new book, "The banker's new clothes" for the March 2 2103 Wall Street Journal.

Bottom line: Banks should issue a lot more equity, a lot less debt, especially short term debt, and a heck of a lot less nonsense.

I admire Anat and Martin. The rest of us read the gobbledygook in the newspapers, chuckle at the faculty lunch -- "Ha ha, xyz is CEO of a huge bank and has never heard of Modigliani-Miller! Ha Ha -- pdq is a senior regulator, and doesn't know the difference between capital and reserves!" -- and then we go about our business. Anat and Martin have admirably taken the bull by the horns. They write opeds, they go to interminable banking policy conferences, they fight it out with bigwig bankers, regulators, and their consultant economists, and endure their scorn. This nice book summarizes their arguments very clearly (without the foaming at the mouth ranting and raving that I would have had a hard time avoiding in their place!)

(Links: This review at the Wall Street Journal (html), in a pdf from my webpage. Admati and Hellwig have a book website with lots of extra material and response to critics.)

Enough preamble. The review: 

Four and a half years ago, the large commercial banks nearly failed, inaugurating our great recession. They were saved by the Troubled Asset Relief Program, Federal Reserve lending and other government support. If you think all that was bad, imagine the ATMs going dark. What has been done to avoid a repetition of these events? Sadly, and despite all the noise you hear about bank regulation, not much.

The central problem, at the core of Anat Admati and Martin Hellwig's "The Bankers' New Clothes," is capital.

In order to make $100 of loans, a typical bank borrows $97—from depositors, from money-market funds, from other banks, or from bondholders—and sells $3 of stock, its "capital." So if only 4% of the bank's loans fail, the shareholders are wiped out, and the bank cannot pay its debts. Worse, if there is a rumor that some loans are in trouble, creditors may "run," each trying to get his money out first, and force a needless bankruptcy. Think of Jimmy Stewart in "It's a Wonderful Life."

When banks are on the brink, all sorts of other pathologies emerge. Bankers and their regulators may try to keep zombie loans on the books, hoping things will turn around. Or bankers may bet the farm on very risky loans that either save the bank or impose larger losses on creditors and the government. Ms. Admati and Mr. Hellwig explain all this nicely in their first few chapters.

The solution seems pretty obvious, no? Banks should fund their investments by selling a heck of a lot more stock and borrowing a heck of a lot less, especially in the form of run-prone short-term debt, as most other companies do.

Far more value was lost in the 2000 tech bust, for instance, than in the subprime mortgages that sparked the 2008 crisis, but the tech bust did not cause a financial crisis. Why? Tech companies were funded by stocks, not short-term debt. Worried shareholders can drive down the price of a stock, but they have no right to demand that the company redeem shares at yesterday's price, so they can't drive the company to bankruptcy in a run. Depositors and other short-term creditors have a fixed-value, first-come-first-serve promise from a bank—they can run.

More capital and less debt would stabilize the financial system in many ways. If a bank wants to rebuild its ratio of capital to assets from 1% to 2% by selling assets, it has to sell half of its assets. Doing so can spark a fire sale, especially if all the other banks are doing the same thing. If the same bank wants to rebuild capital from 49% to 50% of assets, it only has to sell 2% of its assets. That bank will also have a far easier time issuing more stock, rather than selling assets, which is a better way to build equity in the first place.

The U.S. government has instead addressed the risks of banking crises by guaranteeing bank debt. Guaranteeing debts creates perverse incentives, so our government tries to regulate the banks from taking excessive risks: "OK, cousin Louie, I'll cosign the loan for your Las Vegas trip, but no poker this time, and be in bed by 10."

Ms. Admati and Mr. Hellwig show how this approach has failed, repeatedly, over the course of many years—in the 1984 Continental Illinois rescue; in the Latin American debt crisis and savings-and-loan crisis in the 1980s; in the Asian-currency crisis and the collapse of Long-Term Capital Management in the 1990s; and in the recent financial crisis. Each time, our government bailed out more and more creditors in a wider array of institutions. Each time, our government wrote reams of new rules that banks quickly got around.

Now pretty much all of the big banks' debt is guaranteed, explicitly or implicitly through the widely held expectation that a big bank's creditors will be bailed out. But our regulators promise that next time, trust them, they really will spot trouble ahead and do something to stop it—even though our massive bank-regulation machinery failed to notice that subprime mortgages might be a bit risky in 2006 and even though, as Ms. Admati and Mr. Hellwig note, Europe's regulators still consider Greek government bonds to be risk-free assets.

Most basically, Ms. Admati and Mr. Hellwig point out that current regulation is focused on a bank's assets: the loans, securities and other investments that bring money in (and sometimes don't). They want us to focus instead on the bank's liabilities: the ways banks get money and the promises banks make to depositors and investors. Bank assets are not particularly risky or illiquid. Apple's profits from selling iPhones or a mutual fund's portfolio of stocks are far riskier than any bank's portfolio of loans and mortgage-backed securities, or even their much-disparaged trading books. Bank liabilities—too much debt and too much short-term debt—are the central problem that causes financial crises.

What about those "tough" new capital regulations that you keep reading about? They are not nearly as tough as you think. At best, the new Basel III international bank regulation agreement calls for a 7% ratio of capital to assets by a leisurely 2019 deadline. But that is the ratio of capital to "risk-weighted" assets. Risk-weighting is a complex system in which some assets count less against capital requirements than others. A dollar of mortgage assets might count as 50 cents, but it might count as 10 cents or less if it is a complex mortgage-backed security, and zero if it is government debt. When Ms. Admati and Mr. Hellwig unravel those "risk weights," we're still talking about 2% to 3% actual capital.

Foreseeing the usual risk-weighting games, Basel III requires a backstop 3% ratio of equity to all assets. "If this number looks outrageously low," Ms. Admati and Mr. Hellwig write, "it is because the number is outrageously low." Indeed.

This simple truth has been met by howls of protest and layers of obfuscation and derision by bankers, their consultants and many of their regulators. "Oh, you just don't understand the complexities of banking" is the basic attitude. "Go away and let the experts fix this." Well, Ms. Admati and Mr. Hellwig, top-notch academic financial economists, do understand the complexities of banking, and they helpfully slice through the bankers' self-serving nonsense. Demolishing these fallacies is the central point of "The Bankers' New Clothes."

No, they write, it was not always thus. In the 19th century, banks funded themselves with 40% to 50% capital. Depositors wouldn't lend to banks unless the banks had a lot of skin in the game. Without a government debt guarantee—and, early on, without limited liability—shareholders wanted less risk as well.

"Capital" is not "reserves," and requiring more capital does not reduce funds available for lending. Capital is a source of money, not a use of money. When, as Ms. Admati and Mr. Hellwig gleefully note, the British Bankers' Association complained in 2010 about regulations that would require banks to "hold"—the wrong verb—"an extra $600 billion of capital that might otherwise have been deployed as loans to businesses or households," it made an argument both "nonsensical and false," contradicting basic facts of a bank balance sheet. Requiring more capital does not require banks to raise one cent more money in order to make a loan. For every extra dollar of stock the bank must issue, it need borrow one dollar less.

Capital is not an inherently more expensive source of funds than debt. Banks have to promise stockholders high returns only because bank stock is risky. If banks issued much more stock, the authors patiently explain, banks' stock would be much less risky and their cost of capital lower. "Stocks" with bond-like risk need pay only bond-like returns. Investors who desire higher risk and returns can do their own leveraging—without government guarantees, thank you very much—to buy such stocks.

Nothing inherent in banking requires banks to borrow money rather than issue equity. Banks could also raise capital by retaining earnings and forgoing dividends, just as Microsoft MSFT +0.54% did for years. Every dividend drains capital from banks and removes a layer of protection between us taxpayers and the next bailout. Ms. Admati and Mr. Hellwig are at their best in decrying U.S. regulators' decision to let banks pay dividends in 2007-08—amounting to half the TARP bailouts—and to let big banks begin paying out dividends again in 2011.

Why do banks and protective regulators howl so loudly at these simple suggestions? As Ms. Admati and Mr. Hellwig detail in their chapter "Sweet Subsidies," it's because bank debt is highly subsidized, and leverage increases the value of the subsidies to management and shareholders. To borrow without the government guarantees and expected bailouts, a bank with 3% capital would have to offer very high interest rates—rates that would make equity look cheap. Equity is expensive to banks only because it dilutes the subsidies they get from the government. That's exactly why increasing bank equity would be cheap for taxpayers and the economy, to say nothing of removing the costs of occasional crises.

And, in an all-too-short chapter on "The Politics of Banking," they show us how politicians and regulators like the cozy cronyism of the current system. Banks are, of course, "where the money is," and governments around the world use regulation to direct funds to politically favored businesses, to preferred industries, to homeowners and to the government itself. Politicians want to subsidize and protect their piggy bank. Regulators commonly become sympathetic to the interests of the industry they regulate, which advances their careers in government or back in industry. Last week's news coverage of Treasury Secretary Jack Lew's interesting career is only the most recent reminder.

Part of me wishes that Ms. Admati and Mr. Hellwig had been more specific in their criticisms: naming more names and quoting more nonsense, writing a gripping exposé dripping with their justified outrage. But their restraint is wise: Too much exposé would detract from the clarity of their ideas. So readers will have to recognize the arguments and add their own outrage.

Ms. Admati and Mr. Hellwig do not offer a detailed regulatory plan. They don't even advocate a precise number for bank capital, beyond a parenthetical suggestion that banks could get to 20% or 30% quickly by cutting dividend payments. (I would go further: Their ideas justify 50% or even 100%: When you swipe your ATM card, you could just sell $50 of bank stock.)

But this apparent omission, too, is a strength. A long, detailed regulatory proposal would simply distract us from the clear, central argument of "The Bankers' New Clothes": More capital and less debt, especially short-term debt, equals fewer crises, and common contrary arguments are nonsense. More capital would be far more effective at preventing crises than the tens of thousands of pages of Dodd-Frank regulations and its army of regulators, burrowed deep in the financial system, on a hopeless quest to keep highly leveraged and subsidized too-big-to-fail banks from taking too much risk. Once the rest of us accept this central idea, the details fill in naturally.

 How much capital should banks issue? Enough so that it doesn't matter! Enough so that we never, ever hear again the cry that "banks need to be recapitalized" (at taxpayer expense)!


(Update in response to a lot of comments. C'mon, this is a review of a book about banks. It's not my place here to expand the discussion to GSEs' CRA, the run on repo and broker dealers, money market funds etc. On the ATM card that sells bank stock: That card can also sell a share of your S&P500 index. And if you want stable value accounts, money market funds that hold only short term treasuries can provide all the fixed-value assets we could possibly want.)

25 comments:

  1. Where in the world do you get the idea that banks only have 2-3% of "actual" capital? Look at a balance sheet: Wells Fargo has $159B of equity and $1,423B of assets -- an 11% ratio. JPMorgan: $204B of equity, $2,359B of assets -- a 9% ratio. Bank of America: $237B of equity and $2,210B of assets -- an 11% ratio. And so on. Of course, such accounting measures are never perfect, and analysts are tempted to go in and make adjustments, but nothing you do is going to get you to a number as low as 2-3%. For one thing, the FDIC wouldn't allow it -- a bank like that would be deemed critically undercapitalized and shut down.

    When you don't have the basic facts right, don't mock others for complaining that they're misunderstood. As a bank-stock analyst for an investment firm, I don't support everything banks do, but I find that academic economists who've never studied a 10-K or puzzled over an FR-Y9C speak with way more authority than they've earned. For example, you act as if a loan write-down can immediately destroy a functional bank, but in practice this isn't really what we observe. Look at Wells Fargo, Warren Buffett's favorite bank -- they took plenty of *loan* losses but never sustained substantial overall net losses because they're simply very profitable on an underlying basis. For Wells, the flow of interest income on their good assets, less the cost of debt, plus revenue from a host of different types of fees, less expenses to pay employees and fund technology etc. -- what we pro's liked to call "pre-tax, pre-provision profit" before the Fed bizarrely renamed it "pre-provision net revenue" -- has for years been so large that even extreme decreases in credit quality don't cause it to lose money. This doesn't enter anywhere into static capital analysis, and yet it was arguably the most important determinant of which banks won and which banks lost during the financial crisis. Another good example: US Bancorp. Not coincidentally, Buffett has invested in that, too! I've never seen any academic draw attention to this concept -- that underlying profitability is effectively an off-balance-sheet form of capital that has been extremely important in real life in warding off death for financial institutions. Why not? I'm guessing it's in large part because they're extremely removed from all the business details of the banking sector. How many economist, for example, listened to the recent JPMorgan Investor Day, or read through the associated hundred-plus pages of detailed presentations? A lot of useful stuff, but pundits don't care.

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    1. All the numbers are straight from the book. They do a really good job of explaning balance sheets. I believe their disagreement with you is the difference between actual assets and risk-weighted assets. Yes, if you count many assets at 10 cents on the dollar, the ratio of capital to risk-weighted assets is higher. There's a long chapter comparing risk weighted and actual capital ratios.

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    2. No, the reason I stated the exact dollar figures is that I'm taking them straight off *actual* balance sheets. Go to SEC.gov and look up these companies -- the numbers are the numbers. I am extremely well-aware of the distinction between risk-weighted assets and GAAP accounting assets; in neither case is the ratio of any definition of capital to any definition of assets equal to 2-3% for any major bank (probably not anything in the top 100, but don't quote me on that). It's just not the case that "many assets" are counted at 10 cents on the dollar in actual US banks, though this is admittedly more prevalent in Europe (in particular with European residential mortgages). These numbers are only a little bit mysterious -- you can observe them directly and do an okay job at replicating them yourselves.

      For Wells Fargo, for instance, the ratio of risk-weighted assets (RWA) to assets overall (using the new Basel III rules) is $1,389.2B / $1,423B = 98% on average! In other word, the company's risk-weighted assets are close to its GAAP accounting assets. A 10% overall ratio of RWA to assets? No way. Even the European banks aren't there. Go to http://www.bis.org/publ/bcbs240.pdf and look at p. 17 -- the lowest ratio, for Credit Suisse, is above 20%.

      Again, under the US's Prompt Corrective Action standards, a bank with 2-3% capital is in *major* trouble. If you don't believe me, look here:
      http://www.fdic.gov/news/news/financial/2012/fil12025.html
      "Tangible Equity / Total Assets" does not factor in the complex risk-weighting calculations that people complain about.

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    3. [I'm not sure if my last submission went through.]

      No, the reason I stated the exact dollar figures is that I'm taking them straight off *actual* balance sheets. Go to SEC.gov and look up these companies -- the numbers are the numbers. I am extremely well-aware of the distinction between risk-weighted assets and GAAP accounting assets; in neither case is the ratio of any definition of capital to any definition of assets equal to 2-3% for any major bank (probably not anything in the top 100, but don't quote me on that). It's just not the case that "many assets" are counted at 10 cents on the dollar in actual US banks, though this is admittedly more prevalent in Europe (in particular with European residential mortgages). These numbers are only a little bit mysterious -- you can observe them directly and do an okay job at replicating them yourselves.

      For Wells Fargo, for instance, the ratio of risk-weighted assets (RWA) to assets overall (using the new Basel III rules) is $1,389.2B / $1,423B = 98% on average! In other word, the company's risk-weighted assets are close to its GAAP accounting assets. A 10% overall ratio of RWA to assets? No way. Even the European banks aren't there. Go to http://www.bis.org/publ/bcbs240.pdf and look at p. 17 -- the lowest ratio, for Credit Suisse, is above 20%.

      Again, under the US's Prompt Corrective Action standards, a bank with 2-3% capital is in *major* trouble. If you don't believe me, look here:
      http://www.fdic.gov/news/news/financial/2012/fil12025.html
      "Tangible Equity / Total Assets" does not factor in the complex risk-weighting calculations that people complain about.

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    4. John,

      I have not read the book, but you make mention of "It's a Wonderful Life" with the brick and mortar Building and Loan bank.

      Note, that a lot of the trouble in 2007 / 2008 began in the shadow banking system.

      http://www.federalreserve.gov/releases/z1/Current/z1.pdf

      Go to page 65
      L.3 Credit Market Debt Owed by Financial Sectors

      ABS Issuers:
      2007: $4.53 trillion
      2012 - 3rd Quarter: $1.82 trillion

      These were not depository institutions that held deposits and lent from those deposits.

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    5. Well, duh, and a point I've been making loudly all along. The financial crisis WAS a run in the shadow banking system.

      WSJ gave me 10 words to explain what a bank run is for readers who didn't know. Good luck explaining Darrel Duffie's "failure mechanics of dealer banks" in 10 words or less.

      It is fascinating that with a run in the shadow banks, the entire rescue and regulation has been about commercial banks, which if anything had deposits run TO them.

      It's also fascinating that 4.5 years later, our massive regulatory effort has not yet been able to fix money market funds, which is child's play compared to this stuff.

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    6. "The financial crisis WAS a run in the shadow banking system."

      So the crisis was a run in the least regulated part of the financial system where the most sophisticated and best informed market participants dealt with each other. And the conclusion we draw is ...

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    7. John,

      "It's also fascinating that 4.5 years later, our massive regulatory effort has not yet been able to fix money market funds, which is child's play compared to this stuff."

      The ONLY way to fix the money market funds is to make long term private borrowing less expensive than short term private borrowing. The ONLY way to do that (short of an inverted yield curve) is through tax policy.

      The problem with money markets comes from banks that utilize short term funding against long term assets (interest rate spread). The same thing would have happened if the money markets did not exist and banks went to the Fed's discount window to get short term loans.

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    8. Absalon,

      "So the crisis was a run in the least regulated part of the financial system where the most sophisticated and best informed market participants dealt with each other. And the conclusion we draw is ..."

      Have the most sophisticated and best informed market participants figured out a way to borrow short, lend long, pay themselves a king's ransom and remain in business when that spread shrinks?

      Just because they are sophisticated and better informed does not mean they can beat the math.

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    9. The low numbers (2-4%) for equity relative to total assets is typical for European banks, e.g. Deutsche with 2% (as oppsed to 14% of risk-weighted assets). US banks have higher ratios (i) because US did not accept Basel II and instad had a leverage ratio, and (ii) because US has netting for derivatives. If you apply IFRS accounting rules, JPMorgan Chase has equity equal to 4% of total assets and that is not counting off-balance-sheet SPVs.

      Delete
    10. Welcome Martin, congratulatons on a great book, and thanks for helping out with the numbers.
      John

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    11. On the "run in the shadow banking system," one needs to be more precise: Many regulated banks had off-balance-sheet shadow banking subsidiaries for regulatory aritrage, funded by commercial paper. This funding broke down in August 2007, the SPVs were taken into the sponsors' balance sheets and the (regulated) sponsors had a CAPITAL shortage, but no serious funding problems. As time went on, the capital shortage was enhanced by deleveraging, asset sales, and further price declines. In 2008, Bear Stearns and Lehman suffered repo runs, AFTER stock markets (shortsellers) had indicated that solvency of these institutions was in doubt. (Remember the Einhorn critique of Lehman accounting). After the Lehman bankruptcy, there was a run ON money market funds and a run BY money market funds on US investment banks and European institutions.

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    12. Frank

      "Just because they are sophisticated and better informed does not mean they can beat the math."

      I believe Professor Cochrane's theory would be that since the market was unregulated and the participants were all sophisticated they should have been able to plan around the math. To me the collapse of shadow banking suggests that banking in general needs to be regulated.

      This is not to say that Dodd Franks is the right way to go. I understand that the banks preferred a complicated, but ultimately permissive, Dodd Franks over a simpler and more restrictive version. I would have preferred simpler and more restrictive.

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    13. Martin, could you explain further? Chase has 2.4 trillion in total assets and .2 trillion in capital. How do we get from 8% to 4%?


      http://finance.yahoo.com/q/bs?s=JPM+Balance+Sheet&annual

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  2. Wouldn't requiring 100% equity-to-assets from banks simply outlaw deposit banking? Don't we *want* households to allow banks to lend out their money?

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  3. Also, I think we already have banks that are 100% owned by their depositors: credit unions.

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  4. It's become a popular parlor game to write, review, comment and discuss reform after the crisis. We show off how smart we are with our lavish theories about fixing policy. But none of these reforms are implemented. The reason for this is there never really was a crisis. The crisis was averted with the Troubled Asset Relief Program and other fiscal relief and stimulus measures. And, without crisis, there is no change. I think the people in power then, pre-crisis, and now know this and are one and the same. Geitner is most representative here.

    For real change to occur we need a crisis as was most certainly the case during the Roosevelt and Reagan administrations. During those times the people were not just ready for change, they wouldn't be denied.

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  5. "But our regulators promise that next time, trust them, they really will spot trouble ahead and do something to stop it—even though our massive bank-regulation machinery failed to notice that subprime mortgages might be a bit risky in 2006 and even though, as Ms. Admati and Mr. Hellwig note, Europe's regulators still consider Greek government bonds to be risk-free assets."

    I seem to remember in 2005-06 several ranking members of the Senate trying to get Congress to focus both on the subprime mortgage problem (by reigning in Fannie/Freddie) and the new credit swap risk world by suggesting a variety of solutions, among them tightening mortgage credit standards and eliminating lending above 100% of value.

    They were, as I recall, shouted down by several leading Democratic Senators as racists and haters of the poor and downtrodden. And right behind those Dems could be seen, in the shadows, a big batch of economists who today are ADVISING Barack Obama.

    Why does this country always seem to only learn lessons the hard way?


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    1. "I seem to remember in 2005-06 ..."

      Fannie and Freddie and sub-prime were a small part of the housing bubble problem. IIRC the problems with Fannie and Freddie arose after they were handed over to private sector operation.

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  6. There is a fundamental problem the way deposits work in a commercial bank. The loan is risk free, but the depositor earns interest.

    How is that supposed to happen? Only if the government foots the bill. Interest earned from deposits should be a reflection of risk.

    Commercial banks could be replaced by two entities: (1) Equity-funded private companies that invest in the kind of stuff that banks currently invest in. (2) Deposit institutions that offer the risk-free rate of return on investment. Bundling these two financial roles is dumb.

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  7. I agree that the idea of "risk free assets should be abandoned. The one thing we have learned is that all assets are risky, perhaps in inverse proportion to to their appearance of riskiness. Mortgages were supposed to be safe. Government bonds were supposed to be safe. Ha. Ha.

    Having dispensed with that bit of nonsense we should set high minimum capital requirements for all banks. Something on the order of $1 for each $8 of assets. In addition to that big banks should be have more capital in proportion to their size.

    Without getting into the math too deeply, every bank in excess of a given size let us say, about the top 35 banks, should be required to have additional capital = ((ln total assets) - 18)/100.

    Thus JPMorgan Chase with $2.3 trillion would be required to carry 16.1% capital instead of 12.5%. Further the 35 largest banks would be required to have an equal amount of funding derive from long term subordinated debentures. Those instruments (~$375 billion for JPM-Chase) would attract a CDS market that would be a canary in the coal mine for them.

    The third step in my plan would be to license the retailers like Walmart and Kroger to run in-store bank branches, thus ensuring that there would be nation wide chains of banks to compete with the incumbents. The retail banks would be restricted from opening branches outside of their stores and from engaging in wholesale banking or capital market operations.

    The final change that I want is to recognize that the money-market funds are banks and require them to be capitalized like banks. Reserve fund proved that they can be a dramatic source of infection in the system. They should no longer be permitted to do that.

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    1. Some of this I could get behind. Particularly less complex regulation coupled with higher reserve requirements and stricter lending policies.

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  8. Hi John,

    You have me convinced but there are still a few things that cause me confusion. Aren't deposits liabilities of banks? How large a share do they represent of most banks total liabilities? If that share is large then wouldn't high capital ratios significantly reduce funding for banks (I'm thinking that many people would have a very high preference for risk free deposits, pensioners for example, as they can't afford to be exposed to losses from equity risk, anedoctally they might just go back to stasing money in the matress)? Wouldn't high capital ratios lead to falling interest rates for deposits (lower demand for debt) and therefore lower savings and investment? If the elasticity of money demand is very high at low interest rates (people are indifferent between holding money or not) then would we not end up with a very volatile economy?

    Best,
    Joao

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  9. Very interesting book, blogpost and comments. I particularly liked Fat man's idea for capital requirements to increase with bank size. A little something to reverse the artificial economies of scale brought about by tens of thousands pages of regulation.

    Regards,
    J Varland, Sweden

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  10. Thanks to Prof. Cochrane for a very informative book review and post. And special thanks to Prof. Hellwig for his follow-up comments.

    Douglas Levene
    Shenzhen, China

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