Martin Wolf: Why Bankers are Intellectually Naked — Confessions of a Supply-Side Liberal

Sadly, Allan Meltzer is dead. There is a straightforward way to honor him: keep banks from ripping us off and endangering the economy. James Haggerty writes this in a tribute to Allan Meltzer in the Wall Street Journal:

Dr. Meltzer loathed the proliferation of regulations. Financial firms would sneak around them, and market changes would soon render the rules obsolete, he wrote. A wiser approach, he said, would be to require higher capital ratios for larger banks. That would deter banks from growing into behemoths deemed too big to fail, Dr. Meltzer said. If bankers “make the wrong calls,” he said in one interview, they and their shareholders “must be made to pay the price themselves.”

I summarized this passage in a tweet by

Even strongly anti-regulation Allan Meltzer wanted higher required capital ratios for larger banks.

Another way to put it is that Allan Meltzer shared my view that, for banks, especially large banks that can become too big to fail, insisting on high capital requirements that limit bank leverage is a matter of establishing appropriate property rights. With low levels of capital, the stockholders who provide the capital get the upside, but when things go south, they hold a gun to the head of the nation and the world, saying

You can bail us out, or we'll take the whole economy down with us.

Anat Admati, whom I mentioned in the tweet, flagged Martin Wolf's Martin Wolf's March 17, 2013 review of The Banker's New Clothes as one of the best short treatments of the key issues. Here are some key excerpts:

It makes no sense to build either bridges or banks sure to collapse in the first big storm. One makes banks stronger by forcing them to fund themselves with more equity and less debt.
Attentive readers will learn that financial fragility is a feature of the system, not a bug. Banking is more dangerous than they dare imagine. The public have, willy nilly, become risk-bearers of last resort. Protected by this generosity, bankers gain vastly on the upside while shifting the downside on to others. At worst, they can devour a state’s fiscal capacity.
... bankers and their apologists have spun intellectual raiment as invisible as the emperor’s new clothes.
A related item of imaginary clothing is the argument that banks simply cannot raise equity and will have to shrink their balance sheets, instead. The riposte is simple: if the bank is profitable, it must simply be told to retain earnings until higher ratios are reached; if it is unprofitable, it needs to be wound up smartly, in any case.
The problem is bigger than that banks are “too big” or “too interconnected” to fail. It is that they are so complex and so grossly undercapitalised. The model is intellectually bankrupt. The reason that this is not more widely accepted is that bankers are so influential and the economics are so widely misunderstood.

To put it bluntly, bank lobbyists cannot be trusted to tell the truth in this area. Moreover, the bankers themselves and their economist fellow-travelers have twisted their view of reality in order to justify what I once described this way:

... those in the financial industry use low levels of equity financing (often misleadingly called capital) to shift risks onto the backs of taxpayers and rewards into their own pockets. In quantum mechanics, electrons can “tunnel” from one side of a barrier to another. Using massive borrowing to ensure later government bailouts, the financial industry has perfected an even more amazing form of tunneling: the art of tunneling money from the government so that the profits appear on their balance sheets and in their pockets long before the money disappears from the US Treasury in bailouts.

Anat Admati is one of my heroes. There is an easy way to tell whether a proposal involving banks is a sound idea or an invitation to another financial crisis and ripoff of taxpayers: listen to Anat. She is right there on Twitter. And before you get Anat's opinion on the proposal, assume the worst.