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July 18, 2013

Fear, greed and bank capital

Buildings should be strong enough to withstand storms and earthquakes. Similarly, banks should be able to remain upright after massive waves of losses. Engineers have a pretty good idea of how to make skyscrapers strong. The regulators and lawmakers who set the rules for big banks are still struggling, five years after the government rescue of many American and European banks.

Bankers and their defenders say that the struggle is over. The financial structures have been reinforced: deeper capital foundations, new supports added and weak materials removed. But many critics point out that the banks have not done the one thing necessary – to double or triple the ratio of shareholders’ equity to total assets. That is the only sure way, they say, to guarantee that large losses on loans do not threaten the ability of the institution to remain standing.

I think the critics are largely right. As economists Anat Admati and Martin Hellwig explain in their book, The Bankers’ New Clothes, the bankers’ almost instinctive aversion to equity protects bonuses and shareholders at the expense of the general public. Still, in my view banks have a more fundamental problem than poor capital structures. It is society’s unreasonable expectations of what they can accomplish.

The best way to make banks disaster-proof is to eliminate an irrational fear which makes banks too big and to resist the dangerous greed which makes them too brittle.”

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Read Edward Hadas‘ full Reuters blog post here

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