Too Much Risk From Too Much Leverage: Admati

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July 12 (Bloomberg) -- Stanford Professor of Finance Anat Admati discusses the banking industry with Mark Crumpton on Bloomberg Television's "Bottom Line." (Source: Bloomberg)

Is, again your words, "unhealthy and inefficient." how so?

One of the things that's wrong with this industry that we explain a lot in the book is there is just too much risk that comes from too much borrowing, from too much leverage.

So this celebration of earnings -- one of the effects of leverage is that it magnifies.

A little return becomes very big, or big earnings per share, and that can really fool you, lull you into thinking everything is great, without remembering how much risk was taken to generate that.

So in 2006 they also looked good and the problem is what's the risk in there and are we going to discover it too late.

I'm sorry to kind of break in the party, but i am concerned about the banks, very concerned.

It's not just inefficient, it's dangerous, too.

Well, doctor, what do all the recent bank earnings, then, say about the banking industry as a whole?

It's ok for now.

That, you know, we are doing ok.

We are not in a crisis.

When you drive a car at 120 miles an hour, you also could be ok for a while.

Doctor, are banks corporations?

If so, what should their business model be?

Ah, excellent question you asked.

Sometimes it appears that their business is just to generate return.

Usually we teach in finance that just taking risk or just borrowing is not a business model.

You have to actually do something that other people couldn't do by themselves, which goes beyond extracting subsidies from the taxpayers and making returns on the backs of others.

So the business model should be to make, for example, business loans.

This is where we really can use banks.

Otherwise we can have lots of hedge funds doing trading and derivatives and other things.

There's no particular need for the same institutions to do all these things.

But the business model should be to provide services to depositors.

We do need an efficient banking system, credit and also payment system, and all of that is something the economy really, really needs very badly, and that should be the business model, credit worthiness especially.

What do you think of the new capital standards, the bank capital rules in the united states?

Do they go far enough?

Not at all.

They are all still missing a digit by my book of total -- against total assets.

Defined properly, of course, there's a whole issue about the details of how you measure the denominator.

But i don't like risk weight, as you know, an i think leverage is not at all in the right range.

So i'm happy that they go beyond the ridiculous and outrageously low 3%. there's absolutely no justification for it.

None at all.

Well, what would the u.s. and the e.u. have to do in the way of bank capital requirements to satisfy you?

Well, we're going to have to go to certainly multi-digit numbers of leverage, you know, instead of the 5% or 6%. i would go more like 15%. in our book we recommend 20% to 30%. i know it causes people to just freak out, but there's absolutely nothing wrong with it.

That's pretty normal for companies and it's not healthy to really operate in a different level.

There's absolutely nothing about banking that requires this kind of leverage.

They can do everything at the appropriate prices if they have much, much less speed, much less leverage.

Doctor, a bipartisan group of senators has introduced a bill that would re-create the act, the measure that separated commercial and investment banking.

Did the repeal of that contribute to the financial crisis, and would restructuring it be enough to drive a stake through the heart of too big to fail?

Not unless more is done for sure, because, look, in the history of banking there has been a lot of crises that were not about investment banks and derivatives.

Cypress and spain was not about that and the sangse h-savings and loan was not about that.

In addition, even outside the commercial bank, lehman brothers and bear stearns and a.i.g., none of them were deposit-taking institutions.

So the risk can come from non-deposit-taking institutions.

Deposit-taking institutions can take risks in mortgages and other places, that if they can't absorb they can all fail and cause a lot of damage.

So it's not going to be enough to split the functions, even though it could be useful to structure the regulation around it.

But it certainly is not going to solve the key problems if that's all that we do.

We have about 30 seconds left.

Why, in your opinion, have previous attempts to revive glass-stiegal failed?

Well, it's hard to do, actually, and that's probably the key reason.

There is a lot of interconnectedness that's hard to really address.

To make it work they have to oltalize.

We have to do something better we're already doing, so that's

This text has been automatically generated. It may not be 100% accurate.

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