Stanford professor Anat Admati discusses her new paper, in which she explains how a mix of distorted incentives, ignorance, confusion, and lack of accountability contributes to the persistence of a dangerous and poorly regulated financial system.

Anat Admati. Photo by Nancy Rothstein
Anat Admati. Photo by Nancy Rothstein

Just as it takes a village to raise a child, the consistent flaws of the financial system are related to the actions and inaction of its “villagers,” who are motivated by their own incentives. The notion that regulators are doing their best to protect the public is false, as they succumb to “willful blindness.” These are the main ideas expressed in the May 2016 working paper by Anat Admati, the George G.C. Parker Professor of Finance and Economics at the Stanford Graduate School of Business, “It Takes a Village to Maintain a Dangerous Financial System.”((Anat R. Admati, “It Takes a Village to Maintain a Dangerous Financial System,” Just Financial Market: Finance in a Just Society, Oxford University Press (forthcoming 2016).))

Since 2010, following the 2008-2009 financial crisis, Admati devoted much of her efforts to financial regulation. She began with a paper that gained considerable attention, “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Socially Expensive,” (written with Peter DeMarzo, Martin Hellwig, and Paul Pfleiderer),((Admati, Anat R. and DeMarzo, Peter M. and Hellwig, Martin F. and Pfleiderer, Paul C., “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Socially Expensive,” Stanford University Graduate School of Business Research Paper No. 13-7.)) which concludes that arguments supporting the view that equity is expensive are flawed. Then there was a letter to the Financial Times signed by Admati and 19 other economists that criticized the Basel III rules as insufficient, followed by a series of op-eds and more letters.((Anat Admati and others, “Healthy Banking System is the Goal, Not Profitable Banks.” Financial Times, November 2010.))

Then came the 2013 book, The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About It (Princeton University Press), which Admati co-wrote with Martin Hellwig. In a March 2013 article for the Wall Street Journal, John Cochrane wrote that “…Ms. Admati and Mr. Hellwig, top-notch academic financial economists, do understand the complexities of banking, and they helpfully slice through the bankers’ self-serving nonsense. Demolishing these fallacies is the central point of The Bankers’ New Clothes.”((John H. Cochrane, “Running on Empty.” Wall Street Journal, March 2013))

In 2014, Admati was named in Time magazine’s list of the 100 most influential people as well as in Foreign Policy’s list of 100 global thinkers.

The financial system, writes Admati, is not only riddled with conflicts of interest, but also the potential and actual damage from excessive risk taking is largely hidden from view.

In her paper, Admati uses many metaphors to vividly illustrate her ideas. First, she draws a contrast with aviation. Although tens of thousands of airplanes take off and land, often in crowded skies, busy airports, and within short time spans, crashes are remarkably rare. Everyone involved in aviation collaborates to maintain high safety standards, writes Admati, because when crashes occur, their toll is visible, felt by many of those involved and, importantly, can typically be traced to an action or inaction by specific individuals.

Excessive risk taking in banking, by contrast, specifically by excessive use of debt, is hard to detect or trace to specific individuals, and the harm it causes is abstract and spread out. The victims of excessive bank borrowing, specifically the broad public, are led to believe that risks and failures are unavoidable. Because their borrowing is effectively subsidized by the government, when they seek profits banks effectively compete to endanger their depositors and the public. “An analogy,” writes Admati, “would be subsidizing trucks to drive at reckless speed even as slower driving would cause fewer accidents.”

“Institutions considered too big to fail,” adds Admati, “are particularly dangerous because they have an incentive to, and can, become inefficiently large, complex, and opaque. It seems to have become difficult or nearly impossible to manage and regulate them effectively.” Remarkably, just last month (September), Larry Summers made a splash when he declared that the largest banks are not safer, and may even be more dangerous than they were in 2008.((Natasha Sarin and Lawrence H. Summers, “Have Big Banks Gotten Safer?” Brookings Papers on Economic Activity Conference Draft (2016).))

One by one, Admati lists the numerous participants within the private sector in and around the financial system, in government and policy, and in the media and academia who are collectively responsible for its current state. Auditors and credit rating agencies, for example, which Admati calls “private watchdogs,” have conflicted interests because they derive revenues from regulated companies as well as sometimes from regulators.

Revolving doors–the practice by which professionals move back and forth from regulating bodies to regulated corporations–can create conflicts of interest and have been linked to excessive complexity of regulations, which helps create job opportunities for those who can navigate the complex details.

Politicians, adds Admati, find implicit guarantees attractive because they are an “invisible form of subsidy” that appear free because they do not show up on budgets, as the costs associated are ultimately paid for by the citizenry. Lawmakers, Admati points out, “are rarely held accountable for the harmful effect of implicit guarantees combined with poor regulations.”

Admati also lists economists and other experts, who might produce research that support policies determined through a political process. Referring to two papers by Stigler Center director Luigi Zingales, Admati notes that even academic economists, who are considered neutral, are prone to various forms of (possibly subtle) capture or may avoid challenging those perceived to be in power.

The media at times can also introduce biases and confusion, contributing to financial market distortions. Journalists, writes Admati, may have reasons to give opportunities to and avoid challenging powerful people and institutions that are sources of content. People in the media may also lack sufficient background to sort out complex issues and explain what is going on to the public. The result is that a dangerous and poorly regulated financial system persists. Public anger from repeated scandals or from watching movies like The Big Short is useful, but if the anger is unfocused, improving the system will continue to be difficult.

Guy Rolnik: In the last few years, you gradually moved from pure finance into adjacent disciplines like sociology, psychology, and even anthropology. Can you explain why you took this cross-disciplinary approach in your study of regulation?

Anat Admati: I came into it as a finance person doing research in my very tall ivory tower, teaching students basic finance. When the financial crisis hit, even before the climax around Bear Stearns, but especially after Lehman Brothers, I started paying a little more attention to banking and asking myself, “how did this happen?”

The financial system is incredibly important and it enables people to move money across time. How did we move from helping the economy to the system collapsing and needing so many bailouts? What was going on?

When I started looking, I was shocked at what I was hearing, and also what I was not hearing. First, I started reading academic writings and listening to what academics and others were saying. Some of it did not make sense to me.

So I started reading more, asking more questions, and having more informal discussions. I decided it was critical to debunk flawed claims, because they were causing serious harm.

Among the proposals made by academics that I was puzzled by were bonds that convert to equity, so-called CoCos or TLACs. I did not see the rationale for them relative to equity and kept asking, “if we want losses absorbed, why go through this whole complex exercise? A simple security that automatically absorbs losses has already been invented. It’s called “equity.”

Some of what I read, even in a famous banking textbook, ignored material we teach in the basic course. I was shocked. If the textbook is wrong, or if the jargon is very confusing, it’s hard to blame people for not understanding. I realized that it was a little complicated for someone without the background, such as reporters, staffers, or senators, to understand the issues. It can be confusing even for our students or colleagues from other parts of economics or other fields.

I had expected academics and policy makers to engage and care about whether what they were saying and doing was appropriate, particularly since they often know more than the public about the issues and are entrusted to protect the public. But that’s in my ideal world, in the world I hoped we live in. It was not the world I encountered. I was surprised that it was so difficult to get through and engage on important issues that matter to the economy even after such an awful financial crisis and the clear failure of regulations.

My initial involvement included trying to talk to policymakers. I discovered it’s very difficult to get through if your message is challenging or inconvenient. I made some desperate attempts to reach various people, but many would not engage. It was very disturbing. I realized that we hit a raw nerve in banking.

When I did sit down with people, they sometimes changed the subject; they didn’t truly engage, instead often repeating certain narratives. It felt like I encountered a sort of religion, where people want to believe certain things to be true. These were new experiences for me.

GR: Was there one reaction that was more common than others?

AA: Different people reacted differently. Some would engage superficially, some did engage, some engaged in private but continued to say or avoid saying certain things in public.

GR: Is it possible people were opposed to these ideas because they saw them as political in nature? Or did they simply ignore them?

AA: It was more that they preferred to ignore. Academics generally don’t like to talk about politics and feel uncomfortable with controversy. To understand my experiences and guide myself forward, both intellectually and in my advocacy efforts, I had to immerse myself a bit in other disciplines. Otherwise I could not quite make sense of it. That’s how I got out of my silo.

GR: The title of your paper says “it takes a village” (to maintain a dangerous financial system), a phrase you borrowed from the movie Spotlight. Can you explain why you felt the same sentiment applied to the financial system?

AA: I saw that there were many different participants and that they somehow converged to a situation in which it was convenient for all of them to be in that system.

GR: In August 2013 you wrote an op-ed for The New York Times, “We’re All Still Hostages to the Big Banks.” And you wrote many op-eds and short pieces before embarking on your book and since. Why did you choose the op-ed tool?

AA: I felt that writing publicly would be a way to get through. At times, I got colleagues to magnify the message. Speaking publicly makes it harder to ignore what I and others are saying. It also helps inform others so they can make similar points.

I feel it is not merely an abstract intellectual debate. It is a matter of public safety.

GR: But academia does value novel, new, and provocative ideas. Academics are always looking for original new angles.

AA: Cleverness is valued in my part of academia. Elegant models can help careers even if they distort reality and give misleading policy advice. For example, if your model essentially assumes that financial crises are unpreventable like natural disasters, then you will conclude that little that can be done to prevent crises. 

GR: How much would you say are the issues you raise in “It Takes a Village” appreciated among academic researchers?

AA: Most academics are unaware of the issues I am describing. I feel disappointed with academics who are enablers of this system. In the paper I quote someone who is currently working at a major bank and who has enough background to understand the academic research saying to me in reference to some of the academic writings in banking: “with such friends, who needs lobbyists?”

I’m an academic who has done and loves theoretical research and intellectual discussions of details in a seminar room. I belong to this world and still enjoy it. I am still working on theoretical models that help me understand what is going on. But sometimes I feel like we’re too protected in our seminar rooms and conferences. People seem to avoid looking seriously out the window, and in that way we prevent our research and voices from having a more positive impact.