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Anat Admati

Last week the largest U.S. banks received a clean bill of health from the Federal Reserve, which pronounced them capable of withstanding the shock from a severe recession.

Tell that to Anat Admati. A professor of finance and economics at Stanford University's Graduate School of Business, Ms. Admati doesn't have the résumé of someone likely to launch rhetorical bombs into boardrooms. Yet that's exactly what she and her co-author, Martin Hellwig, have done in their new book, The Bankers' New Clothes.

With clarity and wit, the authors take on some of the banking industry's most sacred cows, including its reliance on high levels of debt. That argument has earned them praise from diverse quarters ("the most important book about banking in a very long time," said Kenneth Rogoff, a Harvard economist) but also some vocal critics.

Ms. Admati chatted with The Globe and Mail by telephone from her home in California.

If there is one thing you'd like readers to take away from your book, what would it be?

I want them to know banks are businesses that are not that hard to understand in the end. Banks are not as different from other companies as they tell you they are. There's a sort of a mystique about banking. The book wants to demystify banking so we that can have a discussion about banking as part of the economy, not as something unique and different.

Your focus hasn't been on what banks do with their funds, but the sources of those funds.

We steered the discussion to funding, because the failure of any company is basically the failure to pay debt. So the question is how come you have so much debt that you fail or come near failing? It's a very simple question. But the discussion gets into a box in which we somehow feel like we can't change that. That equity is somehow scarce just for these companies. That's just false. Equity funding is given with the same consideration to all companies.

What I wasn't understanding from the beginning was why these financial institutions were so highly indebted. That was my original question. It seemed that everybody was taking for granted that that's how it is. That it's a debt business. I was like, "What do you mean it's a debt business? They have to have some debt, okay – but do they have to have 95 per cent debt?" I wasn't sure why.

We don't see highly leveraged companies in the economy like that. We don't see companies that routinely have single-digit equity numbers. The banks won't lend to businesses that have so little equity [laughs].

So why are banks different?

Because they want to be and because they get away with it. There's nothing efficient about this way of funding. Nothing. There's nothing about banking that necessitates it or makes it unavoidable.

And the end result is?

It's basically an industry that's allowed to be way [more] dangerous than it needs to be. What we realized too is one of the things about borrowing is it has addictive properties. In other words, once you're highly indebted, among the biases and distortions and inefficiencies that happen is you want to take more risk in general. You might pass up good but relatively boring business lending and do other things. Because decision makers – that is what's so bad about high leverage – won't invest unless they have enough upside.

People have said that your assertion that banks should hold 20 to 30 per cent equity is too expensive and unrealistic.

I've heard it all. Every single thing I have heard. Right now, at least I can say, read my book, because the book unpacks this.

Let me put it to you this way. If you cannot have a viable business at 20 to 30 per cent equity, then maybe you don't have a viable business. That's the way the economy works. How come your business is only viable with 97 per cent or 95 per cent debt which is subsidized [by government guarantees]? In other words, when you can borrow at subsidized rates?

We live in Silicon Valley, where everything is equity funding and we ask why Apple doesn't borrow more. So what's the disconnect between how different banks are from other corporations? When you step into banking, it's like all the rules are changed. It's as if everything is suspended – gravity, everything. [But] how different is it?

These are corporations and they make investments. Their investments are loans. How different are loans from other investments in the economy? How different is their funding? Okay, so they have some debt. They have deposits, fine. But all the money that they create is their debt. So it sits as debt, they owe it to somebody. Then they do stuff with it, and then [if] they lose, what happens then?

You've said your aim is to debunk various fallacies, myths and "irrelevant facts" in the policy discussion around banking. Can you give an example ?

We couldn't imagine the statement that really is the most important used by lobbyists – that somehow more equity, higher capital requirements would prevent banks from lending. We thought, wait a minute. They don't lend when they're already in distress, that's why there is a credit crunch, not because there's more equity. When you have a credit crunch, it's because you already had too much debt and they lost. That's a debt overhang effect.

What was really the moment for me [was when] I opened a textbook for banking. I just wanted to see what they were saying, these people from this island of banking. I saw in the textbook some statement about return on equity. About how ROE is a measure of the cost of different funding. There is an implication that shareholders lose if you have a lower ROE. I fail my students in a basic course for saying something like that. It is really an odd statement. Because you cannot ever talk about return without talking about risk.

If I take money and invest in [U.S.] Treasuries, I get little ROE. So what about it? There's no risk. What does ROE mean without risk? And risk and leverage are intimately related. That's the bread and butter of finance.

This was a textbook by a famous academic, sixth edition. It was part of the culture. And I've heard the ROE argument made and I couldn't really take it seriously. So when I saw it was in a textbook, that was really transformative. I just decided something was really wrong.

This interview has been condensed and edited.

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