The Convergence of George Will and Sherrod Brown

Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

In his latest column, George Will, the dean of conservative commentators, endorsed proposals from Senator Sherrod Brown, Democrat of Ohio and a leading voice for breaking up the country’s largest banks. Mr. Will wrote, as always, eloquently and in no uncertain terms - although the references to revolution do not appear in all hi pieces:

By breaking up the biggest banks, conservatives will not be putting asunder what the free market has joined together. Government nurtured these behemoths by weaving an improvident safety net and by practicing crony capitalism. Dismantling them would be a blow against government that has become too big not to fail. Aux barricades!

With perfect timing, the deep economic thinking that helps explain this convergence between Mr. Will and Senator Brown appeared this week in a form that is easy to read and readily comprehensible by a lay audience: “The Bankers’ New Clothes: What’s Wrong With Banking and What to Do About It,” by Anat Admati and Martin Hellwig (I immediately bought 10 copies).

Put simply, Mr. Will and Senator Brown have both figured out that our largest banks are taking part in an inefficient, dangerous, nontransparent government subsidy scheme. Irrespective of how you view th! e desirable balance between public and private sector in other parts of the economy, the subsidies for global megabanks need to be curtailed.

A smart and immediate change is available, in addition to limiting the size of the largest financial institutions. We should push to increase the equity funding (also known as capital) in this sector relative to its debts, as soon as possible. Professors Admati and Hellwig explain how and why. Anyone who wishes to join in this debate at a serious level must read the book.

The Admati-Hellwig book focuses on bank equity capital, while people at the political level are arguing about bank size. But this is the same issue: how to reduce subsidies to big banks and limit the damage they can inflict on the rest of the economy. Higher equity capital requirements and effective size caps are complementary approaches, not substitutes or competing ideas. Other important statements on these issues include recent speeches by Richard Fisher of the Federal Reserve Bank of Dallas - and see my post last week for other links it contains.

Government officials, particularly those at the Federal Reserve who have been dragging their feet on this issue, need to pay attention. The banking lobby has been confronted and defeated on all intellectual fronts; the bankers have no clothes.

Speaking at an event for the book at the Peterson Institute for International Economics, Morris Goldstein, one of the world’s leading authorities on financial-sector policy, described “The Bankers’ New Clothes” as the most important book in 25 years on these topics. (As a senior fellow at the institute, I suggested an invitation to Professors Admati and Hellwig; however, I did not organize the panel to discuss their book.)

I strongly recommend Mr. Goldstein’s forthright remarks, which start about one minu! te into t! he “commentators” section of the audio recording (click on Item 2 in the audio file; a written version of his remarks is also available).

David Schraa, of the Institute of International Finance, a global association of internationally active financial institutions (look at its board), appeared for the defense. Again, you can review the audio tape and make up your own mind, but to many of us at the event, Mr. Schraa’s counterarguments were weak (available under the same tab, following Mr. Goldstein’s remarks).

Mr. Schraa contended that a great deal had changed since the financial crisis - and that banks now have more capital. This is true, but they started with too little capital (hence their pleas for bailouts) and their required levels of capital are still very low (under Basel III, the international agreement on this issue, banks will be allowed to have as little as 3 percent equity and as much as 97 percent debt as their capital structure).

I refer here to what is known in technical jargon as the 3 percent leverage ratio, which does not allow banks to “risk-adjust” their assets. National capital requirements may end up being higher, but - as in the past - these are likely to turn out not to be meaningful, for example because the risk-adjustment formulas used in official capital calculations prove to be deeply flawed. In my view, the Basel process for increasing bank equity capital is not sufficient and will not end up in a good place.

Mr. Schraa did not seriously engage with the key question: whether today’s low equity capital requirements will be enough to prevent serious crises in the future. He referred to a forthcoming study by his group that wi! ll show t! he big negative effects on European growth of higher equity capital requirements â€" a finding that strikes me as inherently implausible, because the euro-zone disaster is about the interaction between a flawed currency arrangement and a sovereign debt crisis (but, of course, I haven’t seen the study yet.)

Mr. Schraa referred also to the Institute of International Finance’s 2001 study on the supposed negative growth implications from higher equity capital requirements. I’m not impressed by this document - and I’m encouraged that many officials also do not hold this analytical work in high regard. Mr. Schraa warned repeatedly that adopting the Admati and Hellwig proposals would slow growth further because it would raise the funding costs for banks.

Peter Fisher, a former official and senior executive at BlackRock, a leading asset-management firm, deftly demolished Mr. Schraa’s position with his opening words (he starts at 28:30 mark i the same tab linked to above). Mr. Fisher began by agreeing wholeheartedly with Morris Goldstein and stressed that even the most junior credit analyst at BlackRock knows higher equity for banks lowers their overall funding costs, because a bigger buffer against losses and potential insolvency means that the equity of that bank becomes safer while its debt also becomes safer.

The Peterson Institute event was a microcosm of where broader opinion is heading. The academics (Admati and Hellwig) have spoken, in depth, with detail and for a wide audience. They bring with them the financial-policy experts (Goldstein) and the self-described buy-side “bond guys” (Fisher).

They are opposed by the bankers (Schraa), but - as Professors Admati and Hellwig explain in detail - this lobby likes the current opaque subsidy structure very much, including executive compensation based on “return on equity” not properly adjusted for risk.

Political thinkers on the right get this (Mr. Will), as do! politici! ans on the left (Senator Brown). Both are working on communicating this to voters, officials and their various colleagues and allies. The pressure on the largest banks and their dangerous subsidies continues to mount from across the political spectrum.