Capitalisn’t: The Capitalisn’t of Banking

Anat Admati: The banks, to my corporate-doctor stethoscope, are unhealthy all the time. And the fact that they hate equity with this passion is only evidence they have so little of it, too little of it.

Bethany: I’m Bethany McLean.

Phil Donahue: Did you ever have a moment of doubt about capitalism and whether greed’s a good idea?

Luigi: And I’m Luigi Zingales.

Bernie Sanders: We have socialism for the very rich, rugged individualism for the poor.

Bethany: And this is Capitalisn’t, a podcast about what is working in capitalism.

Milton Friedman: First of all, tell me, is there some society you know that doesn’t run on greed?

Luigi: And, most importantly, what isn’t.

Warren Buffett: We ought to do better by the people that get left behind. I don’t think we should kill the capitalist system in the process.

Luigi: In 1981, the socialist candidate Francois Mitterrand won the presidential election in France. It was the first time a socialist won the presidency. You know what the first thing he did was? He nationalized all the major banks.

Bethany: I think I might be able to guess why you’re giving us this history lesson, but tell us.

Luigi: Because I want to discuss how crucial banks have been to the development of the capitalist system and to what extent they might distort capitalism and to what extent they even interact with democracy.

Bethany: Interesting. We all talked a lot about banking. It was mainstream cocktail-party conversation in the wake of the financial crisis. But that seems to have faded, not surprisingly, in the last decade. And even with the SVB collapse, it still didn’t quite come back to cocktail-party chatter.

Luigi: When most of us think about banks, especially for people of my generation and older, the image that everybody has in their mind is the famous scene from the movie It’s a Wonderful Life.

Jimmy Stewart: You’re thinking of this place all wrong, as if I had the money back in a safe. The money’s not here. Well, your money’s in Joe’s house, that’s right next to yours, and in the Kennedy house, and Mrs. Macklin’s house, and 100 others. You’re lending them the money to build, and then, they’re going to pay it back to you as best they can. What are you going to do, foreclose on them?

Luigi: While technically, the bank in the movie is actually a savings and loan, not a commercial bank, there is one aspect of this story that is still pretty much representative of the banking business today and another that is not. The question for you is, which is which?

Bethany: I’m not entirely sure. I guess I would say that savings and loans don’t exist anymore. Banks are no longer subject to runs because of the FDIC, which was created in the wake of the Great Depression that . . . Well, banks are supposedly not subject to runs, at least not for small depositors that have insured deposits up to a set amount. So, that’s a thing that is different today.

But I guess something that is the same today is that we still operate on this system known as fractional reserves, where the bank doesn’t have all the money to give back to customers because it’s making its money in part by lending out customers’ deposits in order to make loans.

Luigi: Both are right, but what I want to emphasize is slightly different. The first one is that in economics, when we have a model of banking, we always think about banks lending to an entrepreneur. In fact, most of the lending from banks is for real estate. With today’s banks, there are $12 trillion of loans, and more than a third of it is just for real estate. If you think about loans to firms, it’s only one-sixth of that.

The other big activity is to lend to consumers. This myth that they are the engine of the economy because they support small businesses is, up to a point, overemphasized. The other thing is that while there was, of course, even at the time of the movie, a Federal Reserve, it had just started, and the lender-of-last-resort function was not working as well as afterward.

In the case of the Bailey Building and Loan, the bank was not insolvent. It was illiquid. All the assets were in long-term mortgages. If all the depositors wanted their money back right away, there was not enough liquidity to pay. However, if the central bank is willing to discount those loans, as the central banks now do, then you can get liquidity, as long as you have enough capital or enough assets to support all the deposits.

Bethany: But isn’t the key question sometimes when a bank gets in trouble that it’s really difficult to tell the difference between insolvency and illiquidity, because it can be the fear of insolvency that makes a bank illiquid? And so, in order to minimize the risk of either real insolvency or the perception of insolvency that leads to illiquidity, we have bank regulation.

I think we have the perfect guest to invite to discuss this: our longtime friend, Stanford professor Anat Admati.

She just came out with an updated edition of her 2013 book, which is called The Banker’s New Clothes. It’s a book about banking and banking regulation that she wrote with Martin Hellwig. Regulation requires banks to finance at least 6 percent of their assets with equity. The core of Anat’s argument—or one of the cores of her argument—is that this is just nowhere near enough, and that, actually, 20 percent to 30 percent of a bank’s assets should be financed with equity.

Luigi: Anat has been making this argument for a long time. A lot of people, me included, at the beginning were more skeptical. As time went by, you could see that a lot of other remedies can be very easily sidestepped, and the beauty of that solution is that it’s so simple.

Bethany: I’d love to hear how that changed. In other words, why were people skeptical of her argument from the beginning, and how did some of these other ideas become so fallible? Or reveal their fallibility maybe is a better way of putting it.

Luigi: I think that financial economists tend not to be interventionists by nature. The more reasonable ones, which I hope I belong to as a group, are willing to intervene when they see a problem, but they’re willing to intervene based on the specific problem.

For example, debt is subsidized from a tax point of view. Why don’t you first go and remove the tax subsidy? Let me be very clear to our listeners. There is a tax advantage to debt that is decided by the federal government, and I think it’s the first order of business to fix.

Bethany: Yeah, it’s really interesting. I have to admit, I had never thought about the idea that the tax deductibility of debt was problematic. And I love, as you know, when there are these things that are structural that we take for granted because they are structural. And then, suddenly, you think, but why is that so?

Luigi: Why don’t you fix the problem rather than trying to go for a pretty strong intervention? Because it’s basically like saying, oh, you can open a grocery store, but you can only open a grocery store with 90 percent equity in your capital structure, which is a pretty big ask.

Now, restated, her point is, taking taxes aside, there is not a real difference in financing with debt and equity—with the provision, however, that it’s clear why deposits are a cheaper form of funds, because they benefit from this liquidity service or payment service that we all need.

And so, deposits are a cheaper force of financing. Banks would like to finance themselves with deposits as much as they can, but then, they don’t want to insure those deposits with having enough of an equity cushion. That’s her point, restated, and I think that point is right.

Bethany: Let’s bring Anat on and talk to her about her arguments, and then we will circle back and discuss.

Anat, I think a lot of people tend to think that this issue of how much capital banks should hold was over a long time ago. Even for people in the know, they think it was a discussion post the financial crisis and that we’ve resolved that and moved on. Yet there was just this hearing in Congress, and the banks, I think, based on what you were saying before we started this podcast, actually have this gigantic lobby called Stop Basel Endgame. Explain what your reaction to the hearing was and where we are. What’s going on?

Anat Admati: Well, people around me were saying, ‘Oh, my god, did you see that hearing?’ And boy, was I flabbergasted. Right off the top, you were saying that the banks hold how much capital they hold. Already, there’s a problem right there.

Let’s explain to your listeners what this is actually about. What it is about is about the funding mix, funding with debt and equity. That’s what it’s about. It’s about leverage.

Jamie Dimon: Despite zero evidence that US banks are undercapitalized today, the proposed Basel III Endgame rule—10 years in the making, shockingly—if enacted, would increase capital requirements by about 25 percent for the largest banks.

Anat Admati: They use that word, “capital”, but it’s really equity funding, and how much equity they use versus borrowed money. Borrowed-money debt is from deposits, from all kinds of other short-term debt, other things. The banks have very little equity. No other company anywhere lives like that with no regulation. The ranking member, Sen. Tim Scott, says what it is about is about more capital sitting on the sidelines.

Sen. Tim Scott: The chairman asked a question about, can you achieve the increased capital requirements? My question is, can you achieve the increased capital requirements without negative consequences to the economy and to lending?

Speaker 12: Senator, we do have concerns that some of the items in the proposal will lead us to either increase the price or to reduce the amount that we lend.

Anat Admati: What they’re going to start saying is, I won’t make a loan. If you don’t subsidize my funding through subsidizing debt, then I won’t make a loan you want me to make. That’s basically what’s going on. And I’m going to tell the poor people and the Black people and the farmers and everybody else that I won’t make them loans. I’m going to weaponize . . . I’m going to recruit all of them to say to their senators, stop Basel Endgame because it’s going to ruin the American dream. This came up a number of times in this hearing that the American dream would be shattered.

Jamie Dimon: The rule would have predictable and harmful outcomes to the economy, markets, business of all sizes, and American households, in ways the Federal Reserve has not studied, contemplated, or shared. Mortgages and small-business loans would be more expensive and harder to access, particularly for low- to moderate-income borrowers as costs for originating and securitizing loans rise.

Anat Admati: Oh, my god, they can’t function. They cannot function. Luigi knows what I’m talking about. You, too. That they can’t function if they have slightly less leverage. Way before banks were limited-liability corporations, they would have to have 50 percent equity and unlimited liability for the owners, because otherwise people wouldn’t trust them with deposits, before deposit insurance.

Now, we’re in a world in which, once you get addicted to living like this, then any change in direction toward more equity appears expensive to you as the shareholder, as the manager of the bank.

Sherrod Brown, the chair of the committee, says these requirements do not stop the banks from making any loans.

Sen. Sherrod Brown: Be clear, absolutely nothing in these rules would stop your banks from making loans to working families, to veterans, to homeowners, to small businesses. Absolutely nothing. The reason banks might make fewer of these good loans in the future is the same reason we’ve been seeing less and less productive banking activity for years.

It doesn’t make your banks as much money as the risky stuff. You know that; we all know that. You’d rather fund risky trading and derivatives bets than boring, bread-and-butter small-business lending. So, even with this rule, you can still lend to small businesses and homeowners. You just might not increase your profits quarter over quarter by quite as much as you increased them last year.

Anat Admati: And, indeed, Sherrod Brown was right in saying nothing in these rules stops them from making any loans. Absolutely nothing.

Luigi: Anat, your proposal with Martin is not to increase equity by a small amount. You want to increase equity to between 20 percent and 30 percent of total assets, when today, in the best-case scenario, it is probably 6 percent of risk-weighted assets.

We don’t want to go into the details about the differences between one and the other, but not only the bankers, but also a lot of our colleagues claim that this will be very expensive and probably will lead to a recession. How do you respond to them?

Anat Admati: Oh, my god, from the first time I started asking, why not 25 percent, I never got a good answer. We’re talking 15 years. Nobody will tell me what the cost is to society for that, because all we’re talking about between the 5 percent and the 25 percent is not that they can’t take deposits. Seventy-five percent is debt. They can have debt. I’m even letting them grow, retain their earnings and grow. What I believe is going to happen to the largest ones is that they will shrink from their own inefficient ways because investors will tell them to shrink.

I’m subjecting them to market-based stress tests. Raise equity. If they cannot raise equity, it’s precisely what killed SVB. They couldn’t raise equity; they were insolvent. Whatever the equity market will give you, that’s a much better stress test than what the regulators are doing. Go raise it. Let’s see what your business model actually is, because what we’re arguing is the business model in banking is too dependent on subsidies right now.

It’s not a healthy corporation. The banks, to my corporate-doctor stethoscope, are unhealthy all the time. And the fact that they hate equity with this passion is only evidence they have so little of it, too little of it. Nobody has ever pointed to me how a recession will actually happen if you have the banks build up their equity. If the industry shrinks, and individual institutions shrink, maybe that’s a good thing.

Bethany: Why would that be a good thing? Explain that a little bit more.

Anat Admati: Well, because some of them are way too big to be governed. The size and complexity of these largest institutions that were there in Congress, you don’t even have them anywhere else so large and so complicated. They couldn’t live in markets ever with this shape. They are just too inefficient. The trillions of dollars on balance sheet are nothing relative to the off-balance-sheet exposures that they have with derivatives and other things that we can’t even fathom how complicated they all are.

And then, they are in all these different countries to the point that they cannot fail. Having an institution that cannot fail without imploding the whole system is not capitalism. That’s capitalisn’t. Specifically, that’s not markets. So, we begin to question whether we even want global banks like that. It’s not clear that banking shouldn’t be constrained to a jurisdiction where they can maybe fail or be regulated effectively.

We know that when there’s global finance, the bankruptcy process doesn’t work for those kinds of companies. We are kind of hostages at that point. The only way to deal with it is to intervene before they fail. And because of the safety net that they have—so many safety nets—they can live like that.

Luigi: I’m sympathetic to the idea of a much higher level of equity in the banking sector. I’m a little bit more worried than you are about the transition phase. One of the things that was brilliant, in my view, of what was done in the recovery phase during the financial crisis, was that at some point after the stress tests, they said, the government is here, ready to give you equity. Either we put in equity, or you find it in the market.

All of a sudden, the banks found a lot of money in the market because they were forced. Today, if we were to tell Jamie Dimon, you have to go to 25 percent equity tomorrow, then, what he’s going to do is try to grow slowly to minimize the pain, which will have an impact on the economy. And if you say, do it tomorrow by issuing equity, that will maybe succeed, but it will massively dilute the equity holders today, which will cause them to reduce in value. I know that you don’t care, but he’s one of those equity holders, and he doesn’t want to do it. So, he’s going to fight tooth and nail.

Anat Admati: That he doesn’t want to do it, we agree. That’s for sure.

Now, transitions. Retained earnings is the first and obvious step to go. First, stop the dividends. Now, Warren Buffett doesn’t pay dividends. All the tech companies for years and years haven’t paid dividends. You invest the money; don’t burn it, but invest it. Even with a 0.9-percent-value investment, you can invest. The money still self-insures your deposits. The only issue is, who insures your deposits, your shareholders or the FDIC?

The bottom line is, both of you. There is no logical argument in terms of social costs and benefits. If they get subsidized, somebody else is paying that subsidy. And you can take that subsidy, if they get less of it, and give it to whomever it is that they were going to make a loan to or whatever. The American economy doesn’t live on credit. It lives on investments.

The fact that you are giving people money in debt form is already because our economy’s debt-fueled anyway, private debt. That’s a deeper problem. But we can go there. Small businesses, other people, may not be able to fund anything without debt, but corporations can. And so can banks because they are corporations.

Bethany: Just on a basic level, I don’t understand how shrinking the banking system wouldn’t cause the economy to shrink, given that the banking system, the provision of credit, is the backbone of economic growth. It seems to me that you shrink one, you shrink the other.

Then, a follow-up, based on something you just said. How do you take that subsidy and give it to somebody else? That sounds nice in theory, but how is that actually doable?

Anat Admati: First of all, you are the one who wrote a lot on private markets, and right now, there’s no problem for anybody to give credit on any money. It doesn’t have to be—

Bethany: I was getting there. We’re coming back to the private markets.

Anat Admati: It doesn’t have to be, we’re going to go there, shut our banking, and all these other scares. You can give credit using any money, not just deposit money. The initiation of mortgages or small-business lending on a JP Morgan Chase balance sheet, it’s virtually nothing. It’s not what they do. It’s like they say that Harvard is like an endowment with a university on the side. JP Morgan Chase is a hedge fund with a little bank on the side.

Except that the bank gives them $2.5 trillion of play money, with investors walking in the door and giving them the money and not having any collateral or contract, just deposit insurance. $2.5 trillion. That’s a nice start. But it’s not true that the banks are the quaint institutions that they invoke in you from It’s a Wonderful Life. That’s not the current institutions.

There are plenty of other people who make loans with all kinds of money, and that’s fine with me. It’s the shadow lenders, mortgage lenders. If you take your private credit markets and all the other lenders, the nonbank lenders for the mortgages, which Amit Seru and some other colleagues showed actually have 25 percent equity or some, or at least, they have twice as much as the banks that are not funded with deposits.

They are there. There are tons of mortgage lenders. Already, the banks are not doing it. Already, it’s going someplace else. And they show you that it’s fine. I’m not scared of the shadow-banking system per se. Most of the time, when you go to the shadow-banking system, which is like a money-market fund, you find the banks. Because the money-market fund ran on the bank, the investors ran on the money-market fund. You just have more layers of intermediation. That’s the problem: throughout the system, where the end borrower is, and where the final lender is, the person who finally invests in 15 layers of intermediation, who knows?

Bethany: One thing you and I have discussed before, where we disagree a little bit, I think you have more faith in the shadow-banking system than I do. You cited the examples of mortgages, but that’s something that had to be bailed out in the pandemic, just as Fannie Mae and Freddie Mac had to be bailed out back in the global financial crisis.

The whole system of financing homeownership had to be bailed out in the pandemic, because instead of making it more stable, we’ve moved it entirely to the shadow-banking system, where mortgages are originated by these companies that, yes, may have 25 percent equity, but then they’re held in so-called M-rates, or mortgage rates, which engage in the whole lending-long and borrowing-short fiasco. They started to collapse in the pandemic and had to be bailed out, or the whole homeownership market would have ground to a stop. Why is that better than a bank?

Anat Admati: I’m not saying it’s better. I’m saying that the entire system is poorly regulated. That includes the shadow banking. I think we ended up agreeing on that. The point being that you create institutions in shadow banking that are completely intertwined with the regular system, and you have to look at the whole system and see how to regulate all that’s going on down the pipe.

Luigi: In 2010, when President Obama signed the Dodd-Frank Act, he said that because of this law, the American people will never again be asked to foot the bill for Wall Street mistakes. There will be no more tax-funded bailouts, period. I don’t know how many minutes of applause followed that statement.

Anat Admati: Two minutes. I counted two minutes. Two full minutes.

Luigi: Now, did Obama and the subsequent president, particularly his former vice president, maintain that promise or not?

Anat Admati: Oh, definitely not. Oh, there’s no question about it. And we just saw the evidence because there are bailouts happening as we speak. SVB was a bailout. First Republic was a bailout, in the sense that a bailout is where you have initial people who made a contract, and somebody prevents a default. It’s the existing banks that are bailing out the failed banks, or the creditors of the failed banks. That’s a bailout in my world.

Whoever are the customers or the shareholders of the surviving banks are paying for this. Now, the large banks have so many implicit guarantees in the sense that they raise money so cheaply. They’ll cross-subsidize the rest of the sector because their subsidies are unbounded from the implicit guarantees: the fact that they will never fail and, therefore, they can always raise money from investors or depositors or somebody.

Look at Credit Suisse. That was despite all their promises that we’ve got some clever debt that will convert to equity, and it didn’t. It didn’t. They blinked, and they provided supports. The FDIC now is bearing losses with JP Morgan Chase. They allowed banks that have more than 10 percent of deposits, against the rules, giving them exemptions to have more.

The FDIC right now stopped imposing any losses on depositors, no matter insured or uninsured. We have effectively unbounded deposit insurance. That is very, very dangerous, because that’s exactly what happened with the savings and loans, in the sense that insolvent institutions go to investors and say, it’s government guaranteed, give me deposits, and I’ll pay you high interest. They will do that until they are run into the ground.

Bethany: Backing up to before these bailouts, to the pandemic, there’s an argument . . . The conventional line of thinking is, look at how well the big banks held up in the pandemic. We fixed them with the new capital requirements coming out of the financial crisis. Why do you not agree with that line of thinking?

Anat Admati: I don’t agree with that because the banks benefited from every support that was given to the entire economy. Without the support to everybody else, it’s not clear how they would have done. They benefited every which way. The Fed is buying corporate bonds; there’s an investment-banking business to do. Everybody was raising equity. People were not defaulting on loans because there were all these forgiveness programs. Think of the PPP program. All of that indirectly helped the banks. They were just standing there, collecting fees, doing nothing, bearing no risk.

They were borrowing at 0.25 percent, lending at 1 percent, getting fees, and the 1 percent loans were either forgiven or guaranteed by the government. They were just sitting there, collecting billions of dollars in fees and interest gaps, spreads, for doing nothing, for giving it to whomever they wanted, including large corporations that it wasn’t even meant for.

Luigi: Today, when I take my money and deposit it at Citigroup, I get 3 basis points. For the listeners, that is 0.003 percent. Basically nothing.

If Citigroup takes that money and deposits it at the Federal Reserve, it gets 5.4 percent. It takes no risk, nothing. Now, the question is, why can’t I, as an individual, put my money at the Fed? I can get 5.4 percent. I would love to get that. And, by the way, there is no risk at the Fed, so it’s risk free. Why is this system in place, and why is this not a major subsidy of our banks?

Anat Admati: It’s an excellent question, Luigi. Why are only the banks getting cheap funding or interest on reserves? Why isn’t everybody getting interest on reserves? This interest on reserves, we do discuss it in the book. It’s a big windfall, and I agree with you, they don’t pass it on. All of us are getting virtually no interest.

I found myself now—because I was actually a depositor in First Republic, having just moved my money from Wells Fargo—getting no interest from JP Morgan Chase. It’s bad, and I completely agree with you. They have so many ways to make money, and this is one of them. Just interest on reserves. Literally. Paying us nothing and getting interest from the Fed.

Luigi: There are some colleagues—and some, actually, are my colleagues at the University of Chicago—who think that having too much equity is bad. That you actually need to keep banks on a short leash, because otherwise, this generates agency problems, so that banks are fragile by design.

Anat Admati: When we wrote the book, in the first edition in 2013, we spent a lot of time writing a chapter about, does fragility discipline bankers, or does debt discipline bankers? I heard your colleagues say in one debate with me that fragility keeps them on the straight and narrow. But the fact of the matter is, when there’s a run—that’s already when they’re insolvent—there’s no evidence that the manager was somehow afraid of a run. In fact, the banks were very reckless with all this leverage before the crisis.

Where is the evidence that the leverage created discipline? That’s just a story on a piece of paper. I’ll tell you that when we wrote the fallacies paper, I had a banker read the whole paper, somebody from 40 years in banking, and he said to me: “Why did you have this long, 10-page section about debt discipline? Is this some kind of an academic thing?” This is what he said. He wouldn’t even think of it. This is a practitioner in banking.

If debt was disciplining, why don’t we hear anybody from the industry wanting better governance like that? That’s not what they ever say. It’s an academic story. When he asked me, “Is this an academic thing?” I said, “Yeah, and unfortunately, we have to debunk it because academics are reverse engineering.” What we see is they’ve got a clever story for why debt’s a good thing.

And that’s the name of the game in academia: the reverse engineering of, we see it, it must be good. The world must solve some problem. I’m going to reverse-engineer a problem that is solved this way. But I have an alternative explanation of why we see high leverage. And it’s not that it’s efficient; it’s despite it being inefficient.

Bethany: You mentioned the phrase “academic myth,” but I’m confused. Aren’t all academics like you and Luigi, brilliant, well-intentioned practitioners of their science? How can there be an academic myth? How can there be somebody who might be invested in supporting the banks? Could that be?

Anat Admati: Look, there are different reasons. When I asked a colleague here why they still say these things, I was told they love their models. Now, I love my models. They are my children. But I don’t take them seriously to the real world, where I look out the window, and I know that my explanation is not the explanation. We have to be able to reject the model based on casual empiricism.

There is no data to show that debt disciplines bankers, never, ever. You can’t even disprove it. In fact, if you take some of these models, some of them, the way they’re written, are not actually about banks. You could apply them to other corporations, and then you ask, why don’t we see the leverage in other corporations, if that’s how to govern?

Bethany: A last question from me, which gets to the last chapter of your book. What does our inability to deal appropriately with banks tell us about democracy’s ability to confront the power of corporations?

Anat Admati: Oh, I think it’s very alarming. After the financial crisis I can . . . Right at the moment, I am very disappointed with Michael Lewis because of his latest book. But in any case, in The Big Short, which we cite extensively, he ends the book with saying: “The problem started with banking when the partnerships became corporations going public, raising money, growing as they did. And that’s when the risk became a black box. And that’s where the people whose money was put at risk lost control over it.” And then, he says: “The problem was not that Lehman Brothers was allowed to fail. The problem was Lehman Brothers had been allowed to succeed.” Which is exactly what we are saying.

Luigi: Anat, you were definitely a pioneer in finance. Even more so, if I may say, as a woman in your generation. I actually did not do a proper study, but I would say that you are probably the most-cited woman who never got elected president of the American Finance Association. Do you feel you have been discriminated against more as a woman or because of your ideas?

Anat Admati: I think it’s both. I also have a style that I challenge people, and they don’t like it. I know of all kinds of things people say behind their backs. I have a lot of stories that I can tell you with academics that would be very disturbing, even without mentioning names. But over a glass of wine, I’ll mention names.

I made peace with the fact that I am not in these crowds and that these crowds exclude me. I have experiences today of people specifically not responding to emails because we picked an argument with some of their papers sometime.

I can tell you that people in high policy positions would not engage. Now, I don’t know if they would have engaged with a man saying what I say. They just didn’t want to hear it. They just didn’t want to hear it. They went to people who were telling them the narratives that they wanted.

I just have to do what I have to do. And it ended up being more important to me to speak truth than to belong to those clubs.

Luigi: Excellent. Thank you, Anat.

Bethany: Thank you, Anat.

Anat Admati: Thank you. Bye.

Bethany: Luigi, you mentioned before we brought Anat on that people have come around to her point of view. I can’t tell, actually, either what you think of her point of view about banks needing to hold far more equity, nor do I know where her ideas sit within the economics profession now. I think it’s still pretty controversial, but what’s your view?

Luigi: My view is that I have warmed up to it as having the benefit of simplicity. A lot of other mechanisms that could be done tend to be clever or cleverer but more subject to lobbying pressure and being undone.

She’s a bit too cavalier on the transition. I think it could be really dangerous in terms of slowing down the economy. I think that, actually, something like what happened after the financial crisis, saying you need to move up, and if you don’t move up, we inject equity—additionally, with a restriction of no dividend, and restrictions on executive pay—all of a sudden, bankers will raise a lot of equity. I think that it is doable, but it requires very strong willpower, and I don’t see any government willing to do that.

Bethany: I definitely can subscribe to her argument that this idea of these global banking behemoths is not necessary. At least, my cursory understanding of the history of financial regulation is that the US felt like we had to copy Europe’s banks, or we were going to get left behind. And Europe’s banks have turned into lumbering, incompetent zombies, basically. So, I’m not really sure that the argument that we had to copy them was right.

But I don’t understand how we go from where we are to a very different model of banking without some kind of economic disruption. And maybe that’s just your transition point, but I guess I’m trying to get my arms around this idea that if banks lend less, doesn’t that shrink the economy? Isn’t there a core of truth to that? Or am I just missing the mark?

Luigi: No, no, it’s not that banks will necessarily lend less. In the transitional phase, if they are allowed to accumulate equity in other ways—for example, by retaining earnings or investing less aggressively, et cetera—they will do that. Because issuing equity in the short term might be painful for the equity holders. And because the managers tend to be large equity holders, directly or indirectly, they might be unwilling to do that.

The only way in which, paradoxically, the transition will not be so costly is if you point a gun to their head and say, you raise equity or we inject equity, and then the problem is solved. But that’s where I say I don’t see any democratic government being able to do that. And so, then, there would be this transitional phase, and in this transitional phase, they will, of course, play a lot of games.

I think that there would be a slowdown in the economy in the transition. So, the transition to her model is rather unrealistic. However, I think it’s incredibly useful to have her position out there because it is very provocative and forces people to rethink. She and Martin are doing an excellent job of poking fun at all the people who provide nontheoretically sound reasons for why equity is more expensive.

Bethany: I also loved her point . . . It was a little bit of a smaller point, but I really loved her point that this idea that it was important for banks to be highly leveraged because that created fragility, which then enforced a form of discipline, that no banker has thought that ever. That comes purely from academia as a way of sort of providing, being a lapdog to the banks in a really strange and interesting kind of way. But that made me laugh. I don’t know if it made you laugh as well.

Luigi: No, maybe I’m too much in the academic world. I think that we academics do have theories that practitioners don’t recognize as valid. That doesn’t necessarily mean they’re not valid. I think in this case, I am more with her than against her. But the fact that bankers don’t recognize this, I don’t think it’s the ultimate litmus test.

Bethany: OK, fine. Fair. I just like to poke fun at you economists. You poke lots of fun at journalists. So, I get to take my pound of flesh when I can.

One thing she also said on the podcast that I really liked that I have not heard her say perhaps as clearly, and I don’t think is as clearly stated in the book, is that we really do need to look at the whole financial system.

One of the things that came out loud and clear to me in reporting on our financial system for my book on the pandemic is that the whole thing is fragile, and shockingly fragile in all these weird places, because it’s a financial system that has been cobbled together over time. We’ve tried to sort of patchwork fix pieces of it through regulation, but without ever stepping back and looking at the whole and saying, does this financial system serve consumers and businesses as effectively as it can? That’s the point of a financial system, to finance consumers and businesses, and where does risk get driven?

I liked that she acknowledged that the shadow-banking system can be as problematic as the banking system. Because I think we’ve sort of, out of laziness or something, in the decade since the financial crisis, where the shadow-banking system has just mushroomed, kind of forgotten about that, as if, when it’s outside the regulated banking system, we don’t have to care about it. The reality is, come a crisis, we always have to care about it, even if it’s outside the regulated banking system.

Luigi: You’re absolutely right. But I have to say that what really took me a bit by surprise is the unwritten story that at some point she will write, which is a personal story. It’s difficult to be a contrarian. Particularly in her generation, it was difficult to be a woman. But it’s particularly difficult to be the combination of the two. And you pay a cost. She did pay a cost, but she was willing to take it. So, I think that eventually there will be a very interesting memoir.

Bethany: I think so, too. She is a truth-teller. That is for sure.