One day in the spring of 2010, Anat Admati, a finance and economics professor at Stanford GSB, opened up a well-known textbook on banking and was astonished by what she saw. "It basically has things in it that are in direct conflict with what we teach in basic finance," she said. "It was shocking. It was absolutely shocking." She stormed into colleague Paul Pfleiderer's office. "I've had it," she told him. "I've heard enough nonsense. This is it. I don't care what anyone says. There is something wrong with banking. At all levels."
For Admati, it marked a turning point. In the 27 years since receiving her PhD in operations research from Yale, her scholarly pursuits had been primarily dedicated to a highly technical, theoretical sort of work that focused on real-life topics such as bargaining and shareholder activism, but did so from a perspective likely to be of interest mainly, or perhaps exclusively, to other scholars. But when Lehman Brothers collapsed and the industry went into free fall, her own field of study, finance, was suddenly taking center-stage in a far broader debate. And slowly at first, but relentlessly and with increasing speed, Admati began asking questions and pushing back against some of the biggest players in the global economy.
As the crisis unfolded, Admati experienced what the rest of the financial world was seeing: panic, fear, and intense uncertainty. "I grew up in Israel, and it was like this feeling of war, this feeling of not knowing what was going to happen." On a deeper level, she says she felt what she calls the "trauma of an academic." The crisis was calling into question some of the key tenets of what she and her colleagues understood about the way companies operated. The mathematical models she had spent her life working on were colliding with reality.
As she started delving into the particulars, she discovered that bankers and banking experts, including academics, were making what she found to be a peculiar argument: that increased capital requirements — that is, mandating that banks use relatively less debt and more equity so they are less vulnerable to declines in their asset value — are "expensive" for society. Moreover, bankers were arguing there were serious tradeoffs between safer banks and lending, growth, and efficiency.
At first, she thought she was missing something. After all, scholars and bankers had been studying this for years, decades even. Numerous textbooks, academic articles, policy papers, and commentary had been written on the subject. And while she was increasingly skeptical of the arguments, she was reticent to step out too far into the public eye. Not an expert on banking per se, she felt she would be viewed as just one of thousands of professors.
Seeking a way to shape and present her views, she enrolled in a program called the OpEd Project, which aims to increase the diversity in the nation's opinion pages, and in particular the number of women contributors. On the first day of the session, run by Stanford's Clayman Institute for Gender Research, facilitators went around the room and asked the women to say what made them an expert. Instead of banking, Admati, a mother of three, focused her attention on a community problem: a rash of teen suicide attempts on the train tracks running through Palo Alto.
Admati had become interested in means restriction — the theory that suicide attempts can be reduced by making it more difficult for individuals to get access to dangers like unguarded train tracks, firearms, and prescription pills. In the evenings, she sat at the crossing with friends and others, including the current Palo Alto mayor. She went to school board and city council meetings and raised money to hire a guard. She wrote an op-ed for the Palo Alto Weekly, published in April 2010, calling on "everyone in this community, organizations, and individuals, to respond to this challenge."
Through this experience, it became clear to Admati that any entrenched problem, whether local, national, or global, could be changed through the involvement of greater numbers of people. Having her first op-ed published emboldened her to focus more publicly on banking.
Admati began saying out loud what she and some of her colleagues had been saying quietly in the hallways and in emails: that banks seemed to be receiving an unwarranted exception from the basic principles of finance. "Banking experts were making up their own rules," she says. "As if banks, as businesses and corporations, lived in a different reality, as if they were on a planet where gravity did not apply."
The questions Admati started asking did not make her particularly welcome in much of the world of banking. Admati worked her way into a conference at the New York Fed and got 10 minutes to express doubts about a proposal championed by some academics that was receiving much attention at the time, something called contingent capital (defined as debt that converts to equity when a certain trigger is hit).
Afterward, one of the participants urged her to write up in more detail the content of her comments. He told her he believed there was a lot of confusion in banking. Deliberations in Basel about banking reform were being derailed by invalid arguments. Those who wanted to counter those arguments did not have enough writing that explained the issues.
Along with Stanford GSB colleagues Peter M. DeMarzo and Paul Pfleiderer, and Martin F. Hellwig of the Max Planck Institute for Research on Collective Goods in Bonn, Germany, Admati spent the summer of 2010 writing a 70-page paper entitled "Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity Is Not Expensive."
The paper concluded that requiring banks to have more equity would not increase their funding costs except for reducing their ability to benefit from subsidies. Whereas bankers may have their own incentives to choose high leverage and to "economize" on equity, their high indebtedness was harmful to the economy, contributed to the fragility of the financial system, and, in fact, distorted banks' lending decisions.
The scholars proposed that regulators set much higher equity requirements than were being put forth, and urged regulators to manage the transition by banning banks' dividends and other payouts to shareholders, mandating equity issuance. Contrary to claims that increased equity requirements reduce lending, it is, in fact, high indebtedness and debt overhang that lead banks to avoid making loans, they said. "U.S. banks paid tens of billions of dollars in dividends since 2007 and through the worst of the crisis," Admati said at the time. "If withholding dividends is done under the force of regulation, there will not be a stigma for any individual bank."
People started to take notice. At a September 2010 conference in Vienna, one of the discussants said he had waited 40 years for this kind of paper. "Can a million bankers be wrong?" he asked, rhetorically. "I now know, yes." Admati and colleagues also discovered they were not alone. Academics have pointed out some of these issues at least since the 1990s. A central banker from New Zealand had said basically the same thing as far back as 2004.
In November of that year she and 20 scholars signed a letter to the Financial Times that argued a healthy banking system must be the goal, not merely "high returns for banks' shareholders and managers, with taxpayers picking up losses and economies suffering the fallout."
From there, she continued to write papers, comment letters, and op-eds, expanding her network further. With encouragement from academic colleagues, including Simon Johnson, an economist at the MIT Sloan School of Management, she wrote a lengthy feature published by the Huffington Post entitled "What Jamie Dimon Won't Tell You," referring to the head of JPMorganChase. The next month, she published a full op-ed in the Financial Times. Then, she published pieces in Bloomberg, the New York Times, and elsewhere.
Still, Admati felt she wasn't getting far enough. She had built a vast network that included some of the stars of the banking system, such as Bank of England Gov. Mervyn King and former head of the FDIC, Sheila C. Bair. She was appointed to an FDIC advisory committee that includes former Federal Reserve chairman Paul Volcker and former Citicorp CEO John Reed. She had some access to the pages of influential media outlets. But only in a book, she decided, could she fully flesh out the issues and try to change the debate and have a more meaningful impact. So, with Martin Hellwig, she began drafting a book for a general audience, The Bankers' New Clothes: What's Wrong with Banking and What To Do About It.
As she worked on that, she and her colleagues published another paper, "Debt Overhang and Capital Regulation." The paper explored why high leverage is inefficient for corporations, but observed that banks are unusual for two reasons. First, the implicit and explicit safety nets that support and subsidize banks mean their creditors are less likely to worry about default than they would be with other kinds of companies. As a result, creditors impose fewer restrictions and covenants on banks, and banks often borrow at lower rates than they would have had to pay based on the risk of their assets. Second, the compensation structure in banking actually encourages high leverage.
Bank management, they write, have incentives to make "large cash payouts such as dividends and share buybacks that maintain high leverage and harm creditors and the public." Indeed, they wrote, the main beneficiaries from high leverage may be bank managers, while "the majority of the banks' shareholders, who hold diversified portfolios and who are part of the public, are likely to be net losers."
The book addresses the idea that years after Lehman's collapse, the financial system remains "dangerous and distorted." It also explores a related, but somewhat different, issue: the politics behind the decision-making processes that have stymied attempts to tighten regulation and improve enforcement. For months, Admati and Hellwig write, they had been "exposing the invalid arguments that were being given against reform. However, important parts of the policy discussion go on behind closed doors. Even when regulators ask for public comment on a proposed regulation, most contributions come from the industry and its supporters, and additional lobbying goes on behind the scenes."
In their attempts to hold meaningful discussions, they write, they discovered that many politicians, regulators, and others "had no interest in engaging on the issues," in part because they preferred to avoid challenging the banking industry. "People like convenient narratives," they write, "particularly if those narratives disguise their own responsibility for failed policies. Academics get caught up in theories, based on the belief that what we see must be efficient. In such a situation, invalid arguments can win the policy debate."
Admati says she hopes her work will alert people to that fact, educate them, and empower them to make changes in the system. "Many people are angry but they don't know what to do," she says. "What we're hoping is to teach them what to ask for — to tell them what can be done."