Interview: Prof. Anat Admati, Stanford University

Anat Admati is the George G.C. Parker Professor of Finance and Economics at Stanford’s Graduate School of Business.

Are banks different? Why are financial institutions so highly indebted, while there are no other highly leveraged companies in the economy?

Banks are different because they have easy access to deposit funds and from that point on they prefer to have as little equity as possible while taking risks. They are immediately in debt overhang. Add government guarantees and subsidies of debt and the desire to always fund with debt is fed and encouraged. For other companies, creditors worry about the various inefficiencies and costs associated with high indebtedness. We explain this in the book, chapters 3 and 9 in particular. 

Why is it the best fix for big banks to use more equity to fund their assets and investments?

This fix involves essentially "reshuffling" of financial claims to correct distortions and put in place more liability and responsibility onto the balance sheet, alleviating the great inefficiency and harm of high indebtedness. It is easier and more effective, definitely also more cost effective, than trying to control the details of what banks do or any solutions that just go and split or shrink the balance sheet without addressing the fragility of the institutions and the system. As long as the system remains interconnected and fragile, and can harm when it gets distressed, the problems remain. 

In addition, high indebtedness distorts lending decisions of banks. They do not make business loans that have limited upside even when they are good investments, because the residual equity does not have enough upside and the investments benefit creditors or others at the expense of shareholders. This is a classic debt overhang underinvestment problem. At the same time, risky, even inefficient investments look attractive to owners/managers, because they can benefit at the expense of creditors (or whoever guarantees the debt). 

How is it possible to achieve more financial reform without sacrificing anything?

Build up the equity cushions and banks can do everything at appropriate economic costs. It does not interfere with taking deposits or providing liquidity and certainly not with lending. 

Thank you very much.

Anat Admati is the George G.C. Parker Professor of Finance and Economics at Stanford’s Graduate School of Business. She serves on the FDIC Systemic Resolution Advisory Committee and has contributed to the Financial Times, Bloomberg News and the New York Times.

Along with the interview the must-read book:

Anat Admati & Martin Hellwig: The Bankers’ New Clothes: What’s wrong with Banking and What to Do about it. Princeton Press, 2013.