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Banks Primed to ‘Collapse Like a House of Cards,’ Banking Expert Warns

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One of the foremost authorities on global banking is warning that the world financial system is primed to experience another collapse, with little likelihood of timely reform to avert the danger.

“We’re all living the illusion, like in 2006, when we thought that everything was all right, but the entire financial system is now living dangerously and close to the abyss” is how Stanford University’s Anat Admati put it in a lengthy interview Wednesday appearing in Globes, a leading Israeli financial newspaper.

Admati’s recent book “The Bankers’ New Clothes,” on the fragility of the global banking system, has earned the finance and economics professor recognition as one of the 100 “leading global thinkers of 2014” by Foreign Policy magazine and similarly as one of Time magazine’s 100 most influential people for 2014.

Ahead of a Globes-sponsored business conference Admati will address on Sunday, Admati sat down for an interview in which she warned that, by some crucial measures, “the banking system is at even greater risk than before” the 2008 crisis.

In particular, Admati notes that average bank size is greater today at $1.76 trillion than it was before the crisis in 2006, when bank size averaged $1.36 trillion.

“These are scary sizes, no matter how you look at it,” Admati tells Globes. “It should be remembered that the big banks are global banks, operating in scores of countries, and legally, they cannot fall. The banks are also interconnected, so a blow to one will hurt the others.”

A key reason for banks’ fragility is their opacity, particularly because their risk exposures to derivatives and to other banks are unknown.

“The result is that everything could suddenly collapse like a house of cards,” she says.

A primary focus of her critique of the banking system is the inefficacy of today’s complex banking regulation. Admati favors a far simpler approach, which is to “greatly raise” banks’ capital requirements. Admati suggests a neighborhood of 20% to 30%, two to three times higher than the single-digit leverage ratios common among U.S. banks.

If banks had to put more of their equity on the line, rather than rely on cheap and essentially subsidized financing from deposits, they would be more heedful of risk, the Stanford professor argues.

The resulting high leverage benefits bank shareholders, and above all bank executives, who enjoy a sort of heads-I-win, tails-you-lose scenario, or as Admati puts it: “there is very high pay in good years, but it does not fall in bad times. Executives don’t even pay a price for fraud and criminality. Even multibillion-dollar fines remain at the level of the corporation, and do not affect executive pay.”

But the biggest losers, she says, are taxpayers and depositors, “because if something goes wrong, they will pay the price.”

So how would raising capital requirements improve the system? Doing so would “reveal which banks are good and healthy, and which are weak to the point of being zombies” by forcing the banks to raise capital on the market.

“If investors aren’t prepared to give a lot of money, the question will be raised, why,” she tells Globes. “If the banks are no good and they have a problematic balance sheet, in which the assets are less than the liabilities, we’ll know it when they try to raise capital. If a bank is a zombie it won’t be able to raise capital, and I fear that there are a lot of banks like that.”

The threat of zombie banks largely goes unnoticed under the current system, and outing them won’t hurt the economy, she says, since they already fail to provide “oxygen for the economy” while putting the economy at great risk.

“Zombie banks only continue to gamble with more and more money to try and cease being a zombie, while simultaneously not recognizing their losses in their balance sheets, in order to avoid collapse. This is not healthy,” she warns.

Without the need to appeal to capital markets, banks are left to the mercies of very merciful depositors whom Admati describes as “especially easy and nice creditors” who — quite unlike the banks themselves — demand “no collateral against their money, only a promise that everything will be all right.”

While a crisis is now in the making, Admati says its trigger and timing cannot be predicted.

Potential sources of vulnerability include the U.S. debt problem which “could return, because it was never really solved,” or could come from student loans, auto loans, a crippled European banking system or a bursting Chinese bubble.

Whatever the source, she warns that “a small collapse can trigger a great crash, because the system is fragile and interconnected.”

The finance professor takes as dim a view of crisis prevention as she does of the system’s vulnerability because of an unengaged public she views as tolerant of the current system.

“The public is ready to absorb the fall of banks. In contrast, the public is not prepared to accept a plane crash, which is why plane safety rules are so strict and there are black boxes, so there will be greater transparency and responsibility,” she tells Globes.

Politics also plays a role, she adds, citing — approvingly — an unnamed senator who said that bankers rule Washington.

Admati dismisses criticism that banking reform, were it to materialize, would trigger a credit crunch. The opposite is true, she concludes:

“When there is too little capital [requirements], risks are taken and money lost [and] a credit crunch is the result.”

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