Excessive Leverage and Risk in Banking

These pages assemble writings on excessive indebtedness (i.e., leverage) in the financial sector, and on capital regulation (i.e., the regulation of the funding mix) of banks and other financial firms.

The pieces are aimed at multiple audiences and vary in length and presumed knowledge on the part of readers.

To make these pages useful, we first describe the main writings and relate them to one another, then provide a page with links to additional pieces grouped by topic.

Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Socially Expensive

Anat R. Admati, Peter M. DeMarzo, Martin Hellwig, and Paul Pfleiderer. First draft August 2010. Revised October 2013.

Aimed primarily at policymakers, this paper takes on claims made in the popular press, by bankers, and by academics and others, suggesting that any benefits to requiring more equity funding by banks must be traded off against the “expense” of doing so. The paper discusses why such claims are either fallacious (Section 3), irrelevant (confusing private costs to banks or their shareholders with costs to society, in Section 4), or consist of unsupported myths that are inadequate for guiding policy (Sections 5-7). The paper also discusses alternatives to equity (Section 8), the impact of leverage requirements on lending (Section 9), and additional claims related to the debate on capital regulations.

A Letter to the Financial Times

November 9, 2010.

Letter signed by 20 academics endorsing the key policy comments made in Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Socially Expensive.

Leverage Ratchet Effect

Anat R. Admati, Peter M. DeMarzo, Martin Hellwig, and Paul Pfleiderer.
Journal of Finance, February 2018, Volume 73, Issue 1, Pages 145–198.

Firms’ inability to commit to future funding choices has profound consequences for capital structure dynamics. With debt in place, shareholders pervasively resist leverage reductions no matter how much such reductions may enhance firm value. Shareholders would instead choose to increase leverage even if debt levels are already high and new debt must be junior to existing debt. These asymmetric forces in leverage adjustments, which we call the leverage ratchet effect, cause equilibrium leverage outcomes to be history-dependent. When forced to reduce leverage, shareholders are biased toward selling assets relative to potentially more efficient alternatives such as pure recapitalizations.

The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It

Anat R. Admati and Martin Hellwig. Princeton University Press. 2013.

The Bankers New Clothes: What’s Wrong with Banking and What to Do about It is an accessible book that requires no prior background in economics. It contains expanded material on banking, capital regulation, and related politics, while especially the discussion of some of the academic myths in banking discussed in the latter paper. (See preface of paperback.)