R4 NatioNal iNstitute ecoNomic Review No. 235 FebRuaRy 2016
*Graduate School of Business, Stanford University. E-mail: admati@stanford.edu. I am grateful to E. Philip Davis, Martin Hellwig, Paul Pfleiderer, Matthew
Zuck and two anonymous referees for helpful comments.
THE MISSED OPPORTUNITY AND CHALLENGE OF CAPITAL
REGULATION
Anat R. Admati*
Capital regulation is critical to address distortions and externalities from intense conflicts of interest in banking and
from the failure of markets to counter incentives for recklessness. The approaches to capital regulation in Basel III and
related proposals are based on flawed analyses of the relevant tradeoffs. The flaws in the regulations include dangerously
low equity levels, a complex and problematic system of risk weights that exacerbates systemic risk and adds distortions,
and unnecessary reliance on poor equity substitutes. The underlying problem is a breakdown of governance and lack of
accountability to the public throughout the system, including policymakers and economists.
Keywords: Banking regulation; capital regulations; banking; equity in banking; capital structure; leverage; agency costs;
leverage ratchet effect; Basel; risk weights; TLAC
JEL Classifications: G21; G28; G32; G38; H81; K23
Introduction
The events of 2007–9 exposed the failure of regulators
to prevent the build-up of risk in the financial system and
showed that flawed rules and ineffective enforcement of
financial regulations can cause significant harm to the
rest of the economy. Despite this experience, the effort
at regulatory reform has been messy and unfocused. The
small adjustments to capital regulations, in particular,
are far from sufficient to protect the public, and the
regulation is still based on a flawed approach that distorts
markets, exacerbates systemic risk, and undermines the
purpose of the regulation.
A healthy and stable financial system is essential for
enhancing the allocation of resources, risk sharing and
economic welfare. If designed and implemented properly,
capital regulation can be a powerful tool for correcting
market failures, reducing externalities, and ensuring that
the financial system serves the economy. The continued
failure of this regulation has permitted an unhealthy,
opaque, inefficient and excessively fragile system to
persist. This system exposes the public to unnecessary
risks and distorts the economy.
The causes for the failure of capital regulation seem
to reflect, at least in part, confusion about why this
regulation is essential and beneficial and about the
relevant tradeoffs. Studies purporting to provide guidance
to policy routinely make flawed assumptions and ignore
the critical distinction between private and social costs
and benefits. The specialised jargon used in banking has
obscured the issues and further muddles the debate.
In this essay I explain the key issues and how capital
regulations fall short. I start by discussing the economics
of funding and the forces that cause banks to use too
little equity, which make effective capital regulation
essential and beneficial. I then provide an overview of
current status of the regulations, point to some key flaws
and discuss some of the claims made in the policy debate.
I close with remarks that place the debate in a broader
governance context.
Are banks special and if so, how?
Capital regulation places restrictions on how banks
and other institutions are funded in order to address
distortions in their incentives. Well-designed capital
regulation ensures that an appropriate part of funding is
obtained and maintained from owners and shareholders
who provide equity. Because owners and shareholders are
not promised any specific payments, they automatically
absorb losses as long as debts are paid.
A mantra in banking is that ‘equity is expensive’. This
view is taken to imply that requiring banks to use more
admati the missed oppoRtuNity aNd challeNge oF capital RegulatioN R5
equity entails meaningful costs that should be balanced
against the benefits of more equity. In fact, the costs
of using more equity are entirely private and incurred
by a small set of individuals. These private costs arise
because when more equity is required these individuals
are less able to pass costs and downside risk to creditors
and to taxpayers, and they are more than offset by the
substantial benefits to the broader society. Policy must
be based on social, rather than narrowly private costs
and benefits.
Before discussing the economics of funding and how
they apply in banking, we must address an insidious
confusion that often perverts the discussion. The
confusion concerns the meaning of the word ‘capital’ in
banking. Many believe that bank capital is analogous
to cash reserves or a rainy day fund, and that capital
requirements force banks to ‘set aside’ or ‘hold in reserve’
idle cash that cannot be used to make loans or other
investments. This suggestion is patently false. Capital
requirements do not require banks to hold anything;
they only concern the source of funding banks use and
the extent to which investments are funded by equity
(or other forms of ‘loss absorbing capital’, as discussed
below). Corporations do not ‘hold’ their own funding;
rather, investors hold (own) claims such as common
shares that are paid from cash flows the firm generates.
If capital is falsely thought of as idle cash, the discussion
of capital regulation is immediately derailed by imaginary
tradeoffs. Nonsensical claims that increased capital
requirements prevent banks from making loans and ‘keep
billions out of the economy’ may resonate with media,
politicians and the public just because the jargon is
misunderstood.1 In light of this confusion and its ability
to muddle the debate, it is disturbing that regulators and
academics, who should know better, routinely collaborate
with the industry to obscure the issues by using the
misleading language and failing to challenge false
statements. If, instead, the language that is used focused
attention properly on funding and indebtedness, the
debate would be elevated and more people would be able
to understand the issues. Instead of saying ‘hold’ or ‘set
aside more capital’ one can say, for example, ‘use more
equity’, ‘rely less on debt/borrowing’, or ‘borrow less’.
The economics of funding start with the observation
that borrowing always creates leverage and magnifies
risk. In financial markets, the required return on any
security depends on risk because investors are risk
averse. A seminal insight, made in 1958 by Franco
Modigliani and Merton Miller and taught in basic
courses in finance, is that rearranging risk among
different investors does not by itself change the overall
funding costs of a corporation.
Are banks so special that this basic principle and
everything else we know about the economics of
funding do not apply to them?2 One way banks are
special is that some of their funding comes from
depositors, who accept lower returns in exchange for
services such as ATMs. To the extent that deposits
involve provision of these services, deposits are a bit
different from other debts, but the logic of Modigliani
and Miller and much of what we know about funding
still apply to banks and particularly to their funding
with equity and borrowing in wholesale markets. In
those markets banks interact with the same investors
who provide funds to businesses and corporations and
who value securities in the context of portfolios using
the same criteria for all investments.3
Importantly, like all other firms, banks have owners
or shareholders who have some discretion about the
mix of debt and equity used to fund the banks’ assets.
And like other firms, banks are more likely to become
distressed or insolvent when they are highly indebted
and take risks in their investments. The distortions and
inefficiencies brought about by distress and insolvency
are particularly relevant for banks, as discussed below.
The funding mix of non-financial corporations is rarely
regulated. Companies can rely on any amount of debt
funding if they find willing lenders to provide this
funding. Despite the tax advantage of debt over equity for
corporations, and without any regulation, most healthy
corporations maintain significant equity levels, and some
borrow very little. It is rare for corporations to maintain
on a regular basis less than 30 per cent equity relative to
their total assets. Retained earnings are a popular source
of internally-generated equity funding. Many successful
companies grow and thrive by routinely using their
profits to make additional investments without taking
on more debt.
Banks, like other companies, can retain their profits or
sell additional shares to investors, which would enable
more loans and investments. Yet banks often choose to
make payouts (such as dividends) to their shareholders
and continue to borrow even while their equity levels
might be 5 per cent or even less relative to their assets.4
Because they operate with little equity and their assets
are often opaque and difficult to value, banks are
fragile. Even small losses can raise concerns about
their insolvency. If depositors or short-term creditors
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are concerned they might not be paid, the result can be
a run, even if the bank is still solvent. Because banks
provide essential services, the collateral harm of their
default and failure can be large. If many banks fail or
become distressed at the same time, the economy as a
whole is disrupted and harmed.5
Does the business of banking imply that banks must be
heavily indebted and use very little equity? Must we,
as a society, tolerate this fragility in order to obtain
the benefits banks provide? The answer is a resounding
No. Nothing about the business of banking makes it
essential or beneficial for banks to operate with the
very low equity levels they choose to maintain. On the
contrary, banks are better and more consistently able to
make all worthy loans at appropriate prices and their
ability to provide reliable liquidity to depositors and
other creditors would be enhanced if they were safer by
using more equity. A safer bank would be less likely to
experience liquidity problems or runs, and because it is
more likely to be solvent when experiencing a liquidity
problem, the central bank will be better positioned to
serve as a lender of last resort.
Why then do banks persist in having such high leverage
and why do bankers fight furiously against regulations
that would force them to use more equity? To answer
these questions, it is useful to consider why nonbanks
do not borrow more even though using more debt
funding can save on their taxes. A key reason is that
borrowing has a dark side.
First, high levels of debt can lead to financial distress
and bankruptcy, which in turn create delays, legal costs,
and disruptions that deplete the remaining assets of the
firm. Second, and more important, borrowing creates
fundamental conflicts of interest between borrowers and
lenders regarding subsequent investment and funding
decisions. The conflicts arise because borrowers benefit
fully from the upside of any risk taken while they share
the downside risk with creditors. Because of these
conflicts of interest, decisions made by the managers
and shareholders of an indebted corporation may harm
creditors and reduce the combined total value of the
firm to all investors. Specifically, decisions on behalf
of shareholders when debt is in place reflect a bias in
favour of riskier investments and additional borrowing
and against relatively safe investments with insufficient
upside and any reduction of leverage.
Anticipating the costs of bankruptcy and the
potential distortions to decisions made against their
interest, lenders typically try to protect themselves
by increasing the interest rate they charge, and they
may attach restrictive conditions to debt contracts
to constrain shareholders’ subsequent actions. Debt
covenants, however, cannot cover all contingencies
and, because they may restrict the flexibility of the
firm to take advantage of beneficial opportunities,
may be renegotiated later. Covenants are also costly
to enforce, particularly if creditors are dispersed and
face a free-rider problem in pursuing them. As a result,
heavy borrowing becomes expensive and unattractive
for many companies despite the tax advantage of debt.
The problem is particularly intense for banks because
they are so highly indebted already.
Admati et al. (2015) explore the implications of
borrower-creditor conflicts on corporate funding. We
show that these conflicts of interest create a leverage
ratchet effect that can have profound impact on the
dynamics of corporate leverage. Borrowing and
indebtedness can become addictive, excessive and
irreversible, because shareholders avoid actions to
reduce the amount of debt and increase the equity, such
that they take downside risk that would otherwise be
borne by creditors. Shareholders may, however, increase
leverage to benefit themselves.
The leverage ratchet effect is particularly relevant for
banks, because part of banks’ business involves taking
deposits, which involves borrowing.6 Once debt is in
place and the conflicts of interest take hold, bankers
prefer to increase leverage and ‘economise’ on equity. If
deposits are explicitly or implicitly insured, bankers have
little reason to worry about depositors withdrawing
funding en masse. Importantly, insured depositors do
not generally monitor banks’ activities and do not put
in place constraints on the risks or additional borrowing
that banks take, on the payouts banks make to their
managers and shareholders. Since deposits are not
secured by collateral, banks can use assets purchased
with deposits as collateral to obtain more debt funding
from investors under attractive terms.7
Thus, bank creditors fail to counter properly the
intense leverage ratchet effect that accompanies heavy
borrowing and, without regulations, the resulting
inefficiencies of distress or insolvency can persist for
extended periods of time. As long as the bank meets its
commitments and its creditors feel safe, the creditors
may not notice if the bank becomes distressed through
losses or additional borrowing, or even if it becomes
insolvent. The addiction to borrowing in banking thus
is tolerated, enabled and encouraged by the passivity of
their creditors and by guarantees and subsidies.
admati the missed oppoRtuNity aNd challeNge oF capital RegulatioN R7
The unusual passivity of depositors as creditors can
cause bankers to forget that deposits are part of the
banks’ debts. For example, in criticising rules that
would force banks to issue long-term debt that might
absorb losses, John Stumpf, CEO of Wells Fargo Bank,
made the nonsensical claim that because his bank has
a lot of retail deposits, it does not have a lot of debt.
Mr. Stumpf was also quoted in the same context saying
“The last thing I need is debt”.8 The story title referred
to Wells Fargo Bank as “debt averse”.
In criticising proposals for long-term debt, Mr. Stumpf
did not advocate more equity, and his bank remains
heavily indebted. If Wells Fargo Bank was actually debt
averse, it could reduce its indebtedness by retaining its
profits or selling new shares. Mr. Stumpf’s objection to
issuing long-term debt likely stems from the fact that,
unlike insured depositors, investors who might suffer
losses, even if this event is highly unlikely, are concerned
with the risk of investing in Wells Fargo Bank, and might
find the bank’s financial disclosures poor.
Equity investors would be even harsher with Wells
Fargo Bank and similarly large and complex banks given
their complexity and poor disclosures. An investigative
report that examined the financial statements of Wells
Fargo Bank, which is less active in derivatives than
other large institutions but has extensive off-balance-
sheet exposures, quotes many investors and accounting
experts stating that the large banks are so opaque
that they are “uninvestible”.9 Andrew Haldane of
the Bank of England has also pointed to the opacity
and complexity of these institutions.10 If regulations
forced more equity funding, appropriate valuations
based on true value creation and fewer subsidies and
better disclosures would restore market discipline that
is currently missing.
In summary, banks borrow too much and resist using
more equity because their managers and shareholders
have strong incentives to do so. These incentives include
the already-high leverage in banking and the guarantees
and subsidies that feed and reward their strong ‘addiction’
and which enable leverage to ratchet up.11 Because the
result of this leverage ratchet is that costs and downside
risks are simply shifted to others while making the
financial system fragile and creating further distortions,
from society’s perspective, and contrary to the mantra
‘equity is expensive’, it is having too little equity in
banking that is expensive and highly inefficient. This
situation can be corrected only by effective regulations.
Unfortunately, the regulations we have are entirely
inadequate and their design adds further distortions.
A critique of capital regulation based on
Basel III
The Basel III accord agreed in 2010 and implemented,
with some variations, around the world, recommends
a modest increase in capital requirements relative to
Basel II. Although it strengthens some definitions and
rules, Basel III still allows equity levels to be much
too low, and it maintains an approach where capital
requirements are stated relative to risk-weighted assets
(RWA). Among other things the regulation establishes
a ‘conservation buffer’. Banks have to rebuild their
buffers by avoiding payouts to shareholders and
bonuses if their equity falls below 7 per cent of RWA,
and more interventions take place if the ratio falls to
4.5 per cent. The new leverage ratio introduced in Basel
III requires that equity be at least 3 per cent of total
assets, allowing assets to be more than 30 times larger
than equity as measured by book value.
Banks designated as globally systemic institutions are
required to have up to 2.5 per cent additional equity
relative to RWA and, in addition, a recent proposal
by the Financial Stability Board agreed upon by G20
leaders in 2015 adds a requirement for banks to use
long-term debt called TLAC (Total Loss Absorbency
Capacity) that is supposed to absorb losses in some
situations.

It is important to note that regulatory capital ratios
are based primarily on accounting conventions that can
be quite arbitrary and vary by jurisdictions. Balance
sheet disclosures tend to obscure significant exposures
to risk, allowing much risk to lurk ‘off balance sheet’,
and to manipulate the disclosures, particularly since
auditors are subject to their own conflicts of interest
and are unlikely to challenge managers.12
Regulatory capital ratios, especially those based on risk
weights, can therefore give misleading reassurances.
Through the financial crisis of 2007–9, these ratios
still appeared strong even as banks were failing and
receiving bailouts and supports. The intense lobbying
by banks against any increase in required equity only
reinforces the view that the requirements are entirely
inadequate.
In addition to the problems related to accounting
measures, there are three key flaws in capital regulations
based on the Basel III accord. (See Admati and Hellwig
(2013a, Chapter 11) for a more detailed discussion.)
(i) Required equity levels are much too low.
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(ii) The use of complex manipulable risk weights that
ignore some risks exacerbates systemic risk and
distorts incentives, particularly because equity levels
are so low.
(iii)Debt-like securities are used in the regulations
although they are complex, unreliable, and entirely
dominated by equity.
Dangerously low equity levels
Bankers and policymakers claim that Basel III capital
requirements are much improved, citing the fact that
they are ‘multiples’ of those specified under Basel II.
The requirements are actually very modest in absolute
terms. Multiplying a small number such as 2 per cent
equity to risk weighted assets in Basel II by a factor of
2, 3 or even more does not result in a large number.
The 3 per cent ‘leverage ratio’ of equity to total value
is outrageously low. Whereas some countries such as
the US have adopted higher leverage ratios (5 per cent
for bank holding companies and 6 per cent for deposit-
taking banks), the levels are still too low. (Much of the
regulation uses risk weighted assets as denominator. As
discussed below this approach is highly problematic.)
Increasing equity requirements substantially brings
about numerous benefits beyond increasing loss
absorption capacity that allows banks to continue
making loans after incurring losses without needing
support. With more equity, liquidity problems, runs
and all forms of contagion are less likely. Moreover, any
loss in the value of the assets is a smaller fraction of the
equity, thus fewer assets must be sold under distressed
conditions to ‘delever.’ Better yet, distortions in banks’
lending and funding decisions due to overhanging debt
are alleviated. As another bonus, more equity is the
best way to reduce the implicit guarantees subsidy that
distorts markets and rewards recklessness.13
All the studies I am aware of that claim to provide
scientific guidelines for the design of capital regulations
have fundamental flaws that render their conclusions
meaningless. The estimates they provide for costs
and benefits of specific capital ratios are based on
many inappropriate assumptions. None of the models
captures properly the relevant costs and benefits and
none provides meaningful estimates that should guide
policy.
A recent paper produced in the Bank of England,
Brooke et al. (2015), cites earlier flawed studies and
provides its own set of flawed estimates. For example,
the benefits of higher capital requirements are only
described in terms of crisis prevention, ignoring all the
other benefits discussed above, including the fact that
more equity reduces the externalities associated with
intense asset sales in distress. The authors presume
falsely that all lending is valuable and neglect the fact
that bad loans are wasteful and too much risky lending
can put banks operating with little equity at risk of
insolvency, which can create disruptions and reduce
lending even if there is no crisis or if losses are absorbed
by investors. As recent experience illustrated, credit
and growth suffer when banks have too little equity.
Credit cycles and distortions are evidence of unhealthy
financial instability that better laws and regulation can
and should contain.
The analysis of the costs of higher equity requirements
in Brooke et al. (2015) is fundamentally flawed because
it fails to make the critical distinction between private
and social cost; the authors provide no coherent model
for how any social costs would come about. The
stated policy regarding ‘too big to fail’ institutions
is to eliminate bailouts. Current efforts focussing on
loss-absorbing debt are said to achieve this objective,
but, as discussed below, the arrangement presumes a
willingness to let banks go into resolution, which is
not credible in a crisis. With equity, this problem does
not arise. Equity is the simplest, most reliable and most
beneficial way to reduce those subsidies while also
enhancing the health and safety of the system.14
The disturbing fact that debt funding is subsidised
and equity is penalised through the tax code is also
not discussed in Brooke et al. (2015), but it is relevant.
There is no economic rationale for the tax subsidies
of debt broadly given to corporations. The Economist
magazine (on 15 May, 2015) called this subsidy ‘a vast
distortion in the world economy’. Having a tax code
that encourages excessive and harmful indebtedness in
banking, which only exacerbates the intense leverage
ratchet effect and the impact of explicit and implicit
guarantees, is perverse. The tax code must be changed,
neutralised or ignored for the discussion of capital
regulation. Even if banks pay more taxes, there is no cost
to society because taxes are to be used by governments
on behalf of the public. 15
When banks have high levels of debt and little equity,
the leverage ratchet effect is intense and as a result the
choices they make in response to requirements specified
in capital ratios might entail unintended consequences
such as reduction in lending or selling assets in ways
that exacerbate price declines for others. To avoid
such problems, especially in transition to higher
admati the missed oppoRtuNity aNd challeNge oF capital RegulatioN R9
requirements, regulators must instruct banks to raise
specific amounts of equity through retained earnings
and new issuance. Inability to raise equity must raise
concerns about the institution’s health. Insolvent banks
are dysfunctional and dangerous; they must be dealt
with promptly. These issues are discussed in Admati
and Hellwig (2013a, Chapter 11) and explored in more
depth in Admati et al. (2015, Sections 5–6).
How much equity should banks have? Historically,
equity levels in banking were much higher than they are
today. As partnerships in the 19th century, for example,
banks’ equity often accounted for 50 per cent of their
assets, and bank owners had unlimited liability, so
owners’ assets could be used to pay depositors. Equity
levels in banking were commonly 20 or 30 per cent of
total assets early in the 20th century, and owners had
double, triple or unlimited liability in the US until after
the deposit insurance was established.16
Admati and Hellwig (2013a) propose that equity
requirements be set at 30 per cent of total assets
and allowed to decline to 20 per cent, maintaining a
conservation buffer between 20 and 30 per cent. Such
levels are considered minimal for healthy companies
outside banking. They are common for hedge funds
and, as noted above, were prevalent in banking before
safety nets were put in place. It is important to note
that the meaning of any number depends critically on
how the ratio is defined and measured and on how
assets are valued, which is extremely challenging. One
thorny issue is accounting for derivatives and other off-
balance-sheet exposures. Another is asset classification,
and whether regulators are able to build equity buffers
in advance and intervene promptly as needed. The detail
of the rules and how they are implemented are critical
for their effectiveness. Supervisors play a critical role.
There are more flawed claims made in the discussion of
capital regulation and about the ‘specialness’ of banks.
A few are taken later in this essay; others are discussed
in writings such as Admati and Hellwig (2013a, b;
2015) and Kay (2015).
Highly problematic risk weighting system
Capital regulations under the 2004 Basel II accord
were based on a complex way to calibrate regulatory
ratios to risk. They did this by attaching a ‘risk weight’
to each asset and defining the denominator of the
capital ratio as the sum of these ‘risk-weighted’ assets.
This approach was maintained and only tweaked
under Basel III. It is abundantly clear that the system
of risk weights used in Basel II did an extremely poor
job of assessing how high capital requirements should
be. In the period leading up to the crisis, banks had
strong incentives to create and invest in highly-rated
securities, particularly if the securities were rated AAA,
because such securities had a zero risk weight and did
not require any equity funding.
Risk weights introduce distortions in multiple ways.
(i) They allow the use of internal models that often
ignore tail risk, thus encourage concentrated tail risks
and increase systemic risk;
(ii) The use of banks’ internal models allows manipulation
of the requirements in order to increase leverage and
risk.
(iii)Risk weights distort bank lending, often away from
business lending and towards government lending
and other investments. A recent example is the
excessive lending of private banks in Europe to the
Greek government in 2001–10. Such lending received
zero risk weight and thus the risk was ignored.
Combined with extremely low equity levels, the
complex risk weights system provides banks many
ways to ratchet up leverage and increase systemic risk
while satisfying the requirements.17 A crude leverage
ratio, at levels significantly higher than any of the levels
implemented today, can go a long way towards making
sure that risks taken in banking are borne by investors
and not by taxpayers. If a system of risk adjustments is
used, it is particularly important that no assets that may
entail risk, even when risk is deemed small by banks or
rating agencies, receive zero or near zero risk weight.
Risk weights should only be used to increase equity
requirements when opacity makes any risk estimation
difficult. The point of equity requirements is to prepare
for the ‘unknown unknowns.’ Having ‘too much’ equity
must not be a concern in the foreseeable future.
Poor equity substitutes
Another flaw of existing capital regulations is that
they try to ‘economise’ on equity by requiring the
largest banks to issue debt securities designated as ‘loss
absorbing capital’. The term that is used is TLAC (total
loss absorbing capital), and the securities are meant to
provide an alternative to bailouts by ‘bailing-in’ some
creditors. A related concept is contingent capital or
cocos, which uses various trigger points to convert debt
to equity. The idea behind these securities is to create
mechanisms other than bankruptcy and, in the case
of TLAC closely related to resolution by regulators,
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which would impose loses on investors other than
shareholders to avoid government bailouts.
In the past, the inclusion of debt as part of capital
regulation has not worked. Tier 2 capital included only
debt-like securities and even Tier 1 capital allowed
many non-equity claims that were held by investors
expecting specific returns. Yet, holders of such claims
did not suffer losses even when banks ran into trouble
and received government bailouts. Nevertheless, and
ignoring the lessons and the economic considerations,
regulators claim that next time will be different.
Persaud (2014) rightly refers to bail-in securities as
‘fool’s gold’. It is unrealistic to expect that regulators
will trigger recovery and resolution processes that are
complex, costly and untested so that losses can be
imposed on debt-like TLAC securities, and that they
would be politically able to follow up with imposing
losses on creditors or mandatory conversion to equity.
This is particularly true if a potential crisis is looming,
since pulling triggers and inflicting haircuts might have
unpredictable consequences throughout the opaque
financial system. A thorny issue concerns cross-border
coordination of any resolution, which bail-in would be
part of. The legal challenges are daunting.18
Since there is no sense in which more equity in banking
is ‘expensive’ from society’s perspective, it is baffling
that regulators devise such complex and unreliable
securities when equity would accomplish the objective
of absorbing losses more simply and reliably at no
additional relevant cost. When risk is taken, losses must
be absorbed by someone. Shareholders who are entitled
to the upside and who absorb losses without the need
to go through complex and costly triggers, are the most
obvious candidates. Especially given the low levels of
equity, the better approach would be to focus entirely on
increasing equity levels.19 It makes no sense to plan for
scenarios that would be costly and disruptive even in the
best case when much more can be achieved by trying to
prevent reaching those bad scenarios. Moreover, equity
is already on the banks’ balance sheet and often trades in
a well-developed and liquid market. None of this holds
for the complex and untested alternatives.
By far the most important approach to enhancing
financial stability and increasing loss absorbing capacity
is a dramatic increase in equity requirements for banks
and other financial institutions. Genuine, reliable,
credible and cost-effective loss absorption cannot be
achieved by any of the other means. The use of debt
securities instead of equity ignores both the lessons
from past attempts and the economic considerations.
This approach is misguided, poorly motivated, and
fraught with problems; it represents a false hope.
Is equity scarce for banks?
A question often asked regarding proposals to increase
equity requirements for banks dramatically is ‘where
would all this ‘new’ equity come from?’ The concern is
misplaced. As explained in Admati et al. (2013, Section
7), a change to the funding mix of banks, even a radical
change, does not by itself interfere with any of the
overall productive activities in the economy and does
not involve any radical change in the way risks in the
economy are held and shared. All that is involved is a
certain ‘reshuffling’ of financial claims.
Higher equity requirements help place risks where
they should belong, namely with shareholders, for the
purpose of aligning incentives and reducing distortions.
Requiring more equity funding ‘privatises’ risks that are
otherwise borne by governments and taxpayers. Once
risks are privatised and conflicts of interest are reduced,
undistorted markets can determine the appropriate
allocation of resources and the size of individual banks
and of the industry. Currently, markets fail because of
the distortions of excessive leverage and subsidies and
flawed regulation that further distorts incentives.
The easiest way to implement the transition to higher
equity requirements is to ban payments to equity until
banks are better capitalised. Avoiding cash payouts to
shareholders, and even requiring that some executive
compensation comes in the form of new shares rather
than cash, can build up equity buffers. It may also be
useful for regulators to mandate specific amounts of
equity issuance. Banks that cannot raise equity must be
viewed as failing a basic market stress test. They may
well be too opaque, insolvent, or too big and inefficient.
Such institutions should not persist.
Instead of relying on market tests, regulators use annual
stress tests to reassure themselves and the public that
the banks are safe enough. The premise of the stress
tests is the flawed notion that equity is scarce and
expensive and that banks should have ‘just enough’ of
it. In fact, there is little harm and much benefit in more
safety, and the stress tests give false reassurances. The
tests rely on many of the same flawed measures used
in capital regulations and on numerous unreliable and
untested assumptions. 20
It is impossible to predict with any precision how an
actual crisis, which may come from an unexpected
admati the missed oppoRtuNity aNd challeNge oF capital RegulatioN R11
direction, would play out in the highly interconnected
system. The opacity of the system and the existence of
many layers of intermediation make it difficult to assess
true counterparty risk and the correlation between
underlying macro risk and counterparty risk. Risks
that are assumed to be transferred and dispersed may
instead be concentrated elsewhere, as happened in the
case of AIG. Hansen (2013) discusses the difficulty of
estimating systemic risk with any precision, and Hellwig
(2014) concludes that given the challenge of devising
macroprudential regulations, ensuring significant
equity buffer for banks must be a key approach to
reducing systemic risk.
Flawed excuses
A claim often made against increasing equity
requirements is that it would force activities to move to
the ‘shadow banking system.’ This argument is flawed.
The shadow banking system actually grew as a direct
result of the failed enforcement of previous (light)
regulations. Regulated institutions were able to hide
risk exposure from regulators in the shadow banking
system, and they continue to do so.
The lesson is that we must do better at enforcing
regulations. Tracing the exposures of the biggest
institutions, which can be viewed as ‘shadow hedge
funds’ given their enormous scope and complexity,
would be an important start. Pillar 2 of the Basel
agreement gives authority to supervisors to intervene in
imprudent practices, and they must use this authority
to prevent blatant attempts at regulatory arbitrage.
If effective enforcement is deemed impossible, maybe
radical solutions, such as those proposed in McMillan
(2014), should be considered.
Another argument against higher equity requirements
is that the requirements must be coordinated
internationally to maintain a ‘level playing field,’ or
that it is a policy priority to help ‘our’ banks succeed
in global competition. Such flawed policy concerns
explicitly interfere with financial stability, as admitted
in Brooke et al. (2015). In fact, banks are in competition
not only in markets for financial services but also in
markets for inputs, including scarce talent. The people
that they have drawn into the financial sector have
not been available to other industries. Extolling the
competitive success of the financial sector ignores the
opportunity costs of these successes.
For the economy as a whole, the question is not
whether banks are successful but where resources are
most usefully employed. We usually rely on the market
system to guide resources to their best uses. Absent
distortions, a firm’s ability to compete successfully in
input and output markets is prima facie evidence that
its use of the resources is economically desirable. But
this assessment is unwarranted if market functioning is
distorted by externalities and/or government taxes and
subsidies.21
Policymakers must focus on protecting their citizens,
not ‘their’ banks. Implicit guarantee subsidies distort
competition and impair the ability of the market
system to provide proper allocation of resources.
More generally, the economy may be putting too
many resources into the financial sector. In that case,
eliminating these distortions through higher equity
requirements will improve the market system and
enhance economic welfare, even as financial-sector
activities are reduced. The global success of banks in
Ireland, Iceland and Cyprus has brought disaster on
their citizens, and nations with large banking sectors
should be particularly concerned with protecting their
citizens from reckless, excessively leveraged banks.
Concluding remarks
Our fragile and unhealthy financial system would be
much better able to support credit and growth if capital
regulation were better designed and implemented. The
view that equity levels in Basel III are much too low is
shared by many. For example, in 2010 a short letter
signed by twenty academics (Admati et al., 2010)
pointed to the key flaws discussed here and urged more
radical reform.22 Hoenig (2013) [from FDIC] called
Basel III ‘a well-meaning illusion.’
Despite the extremely strong case for requiring much
more equity and for improving the design of the
regulation, recent statements from regulators suggest
that the debate over capital regulation is largely
over, with virtually no major improvements over the
flawed Basel III.23 A story on 1 December, 2015 with
the headline ‘Bank of England draws the line on bank
bashing’ quotes Governor Mark Carney saying “there
is no Basel IV”. Bankers were of course quite pleased.24

Instead of questioning their assumptions, re-examining
the issues, and acting in the public interest, policymakers
and many others, including academics, have maintained
flawed narratives and displayed wilful blindness.
Instead of simple and cost-effective regulations to
counter distorted incentives that harm the economy,
regulators have devised extremely complex regulations
that may not bring enough benefit to justify the costs
but which allow the pretence of action. 25
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The quest for high equity requirements should not
be viewed as ‘bank bashing’ but as a common sense
approach that is based on a proper costs and benefit
analysis. Individuals who work in banks respond
in predictable ways to their incentives to benefit
themselves. The rules must recognise and account for
these incentives. Where possible laws and regulations
should be designed to reduce the conflict between
what is good for banks and those who work for them
and what is good for the broader public. When laws,
regulations, enforcement, and overall governance fail,
it is policymakers and watchdogs who deserve criticism
for creating flawed rules that tolerate recklessness and
exacerbate distortions, and for betraying the public
trust.
Martin Wolf, who served on the UK Independent
Commission on Banking, wrote an excellent summary
of the issues related to capital regulations: “Allowing
such important businesses to operate with almost no
equity cushions encourages dangerous conduct. Banks
are not special, except for what they are allowed to get
away with. 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.” He
concluded by asserting that “we have failed to remove
the causes of the crisis. Further such crises will come”.26
Many have reached the same conclusion, including
among regulators and the industry. 27
Why are bankers so influential, and why are the
economics so widely misunderstood? The problem
appears to be rooted again in people’s incentives and the
lack of accountability. It is easier and more convenient
to believe that free markets achieve efficient outcomes,
and to avoid challenging those with power. The ‘other
people’ whose money and welfare are at stake are either
unaware that they are harmed or unable to do much
about it. Governance and control appears broken at
all levels. When the public is confused about the issues,
there is no accountability for flawed claims and bad
policy.
It is both sobering and alarming to contemplate the
failure to learn key lessons from a crisis as harmful
as that of 2007–9. A developed financial system meant
to allocate risk and resources efficiently continues to
distort the economy and endanger the public. My fear
is that this system persists because it benefits powerful
people, and that even if we experience more major
crises in the future, convenient narratives and narrow
interests will again prevail to prevent effective reform.
My hope is that more people engage on these issues,
gain better understanding, and do what they can
to change this situation. The issues go beyond crisis
prevention; our banking system is inefficient, distorted
and harmful every day. Collectively, we must find ways
to improve it.
NOTES
1 Such claims are made routinely by lobbyists. A recent example
is Tim Pawlenty of the Financial Services Roundtable (see
‘Fed lifts capital requirements for banks’, Ryan Tracy, Victoria
McGrane and Justin Baer, Wall Street Journal on 20 July, 2015.
For more discussion, see Admati et al. (2013, Sec 3.1), Admati
and Hellwig (2013a, Chapters 1, 6) and Admati and Hellwig
(2015, Claims 1–2).
2 This question is addressed in Admati et al. (2013, 2015), Admati
and Hellwig (2013a, Chapters 4 and 7–10; 2015), Pfleiderer
(2015), and Kay (2015).
3 In some of the academic literature on banking, the statement
‘MM does not apply to banks’ is used to postulate frictions that,
under the assumptions of the models, might be addressed by
borrowing, while conveniently ignoring the enormous frictions
and collateral damage on the system that borrowing creates.
See Admati and Hellwig (2013a, Chapters 3, 6, 8 and 9; 2013b),
and Pfleiderer (2014; 2015).
4 These ratios may depend on accounting convention and they
might be poor measurements of indebtedness or solvency. The
so-called distance to default depends on the market value of
the assets relative to the amount it would take to settle all
the debt.
5 See Admati and Hellwig (2013a, Chapter 5) for a discussion
of contagion effects in banking.
6 It is sometimes argued that debt helps resolve governance
problems between managers and shareholders. These
considerations, however, do not apply to the funding
considerations of banks that are the main focus of this chapter.
For discussions of debt as a ‘disciplining’ device for managers,
see Admati et al. (2013, Section 5) and Admati and Hellwig
(2013b), which represents an ‘omitted chapter’ from Admati
and Hellwig (2013a).
7 In the case of repo and derivatives, there is a also a bankruptcy
exemption that further reassures creditors and lowers their
concern with the overall risk, thus adding fragility. See, for
example, Skeel and Jackson (2012). Brunnermeier and Ohemke
(2013) discuss the shortening of maturity as another distortion
in funding that is due to conflicts of interest and relevant in
banking.
8 The first quote is from ‘Wells Chief warns Fed over debt
proposal’, Tom Braithwaite, Financial Times, 2 June, 2013. The
second from ‘Fed disaster plan is a bitter pill for debt-averse
Wells Fargo,’ Jesse Hamilton and Ian Katz, Bloomberg, 30
October, 2015.
9 ‘What’s inside America’s banks’, Jesse Eisinger and Frank
Partnoy, The Atlantic, January 2013. On the huge complexity
of the structure of the largest banks, see Blundell-Wignall et
al. (2009), Advisory Scientific committee (2014) and Carmassi
and Herring (2014).
10 See ‘We should go further unbundling banks’, Andrew
admati the missed oppoRtuNity aNd challeNge oF capital RegulatioN R13
Haldane, Financial Times, 2 October, 2012. Kerr (2011) shows
how banks can artificially inflate reported profits and capital
levels and mislead investors and regulators. There has been no
meaningful change in this situation. Accounting properly for risk
in derivatives markets and exposures off balance sheet remain
major challenges to investors and regulators.
11 Admati and Hellwig (2013a, Chapters 7–10), Admati et al. (2013;
2015) and Kay (2015) discuss the incentives in more detail. On
distinctions among shareholders, see ‘The great bank escape’,
Anat Admati, Project Syndicate, 31 December, 2012.
12 Huizinga and Laeven (2012) show that distressed banks are
prone to manipulating their financial statements. Kerr (2011)
explains how banks can manipulate reported profits and
regulatory capital. On conflicts of interest in auditing firms,
see, e.g., Shah (2015). On this and related governance issues,
see, e.g., ‘Investigate KPMG’s audit of HBOS, urges Tyrie’, Tim
Wallace, Telegraph, 14 December, 2015.
13 Admati et al. (2013, Section 2) and Admati and Hellwig (2013a,
Chapters 6 and 13) discuss the benefits of higher equity
requirements in some detail.
14 Implicit subsidies are discussed in detail in Admati and Hellwig
(2013a, Chapter 9) and in Admati (2014). Admati et al. (2013,
Section 9) discusses capital regulation and lending.
15 On tax and other subsidies, see Admati et al. (2013, Section
4), Admati and Hellwig (2013a, Chapters 6 and 9) and Admati
(2014).
16 See Admati and Hellwig (2013a, Chapter 2) and references
there, as well as Turner (2014).
17 Hellwig (2010), Admati and Hellwig (2013a), Bair (2012), and
Haldane (2011, 2012) discuss the issues in some detail.
18 For more on the legal challenges associated with TLAC debt, the
bail-in concept, and cross-border resolution, see, for example,
Wilmarth (2015). In Europe, the implementation of a banking
union with deposit insurance and resolution is mired in legal
and political complications as of this writing.
19 Admati and Hellwig (2013a, pp. 187–8) and Admati et al. (2013,
Sec. 8) elaborate. Similar considerations apply to so-called
contingent capital.
20 Dowd (2015) provides an extensive discussion of the
weaknesses in stress tests.
21 See Admati and Hellwig (2013a, Chapter 12) for more
discussion.
22 The full text and signatories’ names and titles are available
at http://www.gsb.stanford.edu/faculty-research/excessive-
leverage/healthy-banking-system-goal. The 15 per cent figure
was meant to illustrate that the 3 per cent figure in Basel III is
entirely in the wrong range. As discussed above, exact numerical
ratios are not meaningful until an appropriate measures of the
total assets is specified, which involves thorny accounting issues.
Links to two other letters from many academics published in
2011 and many other writings are provided at http://www.gsb.
stanford.edu/faculty-research/excessive-leverage.
23 ‘Bank regulators see mood shift as rule-making phase nears
end’, Huw Jones and Steve Slater, Reuters, 22 October, 2015
quotes Andrea Enria, chair of European Banking Authority:
“The rule-making phase in banking is coming to an end. We
will then move to consistency and implementation issues”.
William Coen, secretary general of Basel Committee on Bank
Supervision stated: “there’s not a prevailing view among the
Basel Committee that we need more and more capital, I think
we’ve got a good handle on the amount of capital”.
24 Financial Times headline, report by Chris Giles, Caroline Binham
and Martin Arnold.
25 On wilful blindness, see Heffernan (2012). Other People’s Money
is both the title of Kay (2015), a chapter title in Luyendijk
(2015) and the final chapter title of Admati and Hellwig (2013a).
Regarding the academics, Admati et al. (2013, Section 5–7),
Admati and Hellwig (2013a, b; 2015) and Pfliederer (2014) point
to flawed models and analyses and their misuse in policy.
26 ‘Why bankers are intellectually naked’, Financial Times, 17 March,
2013.
27 See, e.g., Luyendijk (2015), which is based on many interviews
and concludes that the system has “an empty cockpit”.
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