«We’ve wasted an important opportunity to fix the system»

Anat Admati, Professor of Finance and Economics at Stanford University warns that the too big to fail problem is not solved and that the financial system remains vulnerable.

Never again should taxpayers have to bailout a systemically important bank. This was the promise of policy makers around the globe after the financial crisis of 2008/09. Ten years after the crash of Lehman brothers, the results remain disappointing. «The financial system is not much safer», says Anat Admati. The renowned finance professor at Stanford University warns that many big banks still aren’t robust enough to weather a severe storm in the financial markets. Thereby, the still pose a threat to the overall economy and society. That’s also the case in Switzerland where safety measures for too big to fail banks like UBS (UBSG 11.835 0.04%) and Credit Suisse (CSGN 11.64 0.09%) rely too much on unconventional funding instruments like Coco bonds.

Professor Admati, ten years after the failure of Lehman Brother the trauma of the financial crisis seems to be overcome. But how safe is the global financial system today really?
People like to point to all kinds of numbers that should give us comfort. But I don’t think the financial system is that much safer today. We know that some of the biggest financial institutions got much bigger. In addition to that, the system remains very opaque and control is very fragmented across nations. To some extent there is even less international cooperation at the top.

What went wrong?
There is this tendency to view regulation as something on the line of more or less where somehow more regulation is always costly. In other words, there is some kind of loss you have if you regulate, they say. But in fact, some regulations are just correcting what the markets fail to do, for example insured depositors do not monitor the bank’s risk. A bank failure also creates collateral harm to the economy. That’s why we need safety. So, if we had had a more serious discussion about what really led to the financial crisis and less of this battle of narratives we would be in a better place today. But there is still so much confusion when it comes to financial regulation. This is very disappointing and very concerning. We’ve just wasted an important opportunity to fix the system.

What do you mean by that?
There is a great focus of the policy makers on responses to crises. But if the government is behind the downside of a bank failure than everyone involved is trying to come along as long as everything works out. Regulation can prevent a crisis. But instead there is too much discussion of how to deal with a crisis once it happens. That’s as if the crisis itself, and its severity, are from nature. There is too little recognition of what should be done in advance. Take road traffic as an example. We have seatbelts and airbags to protect us when we drive a car. And there are also ambulances who can come to the rescue. But there’s a reason we have speed limits and other traffic laws to begin with. So if you forget that you can prevent accidents in advance then you’re basically just missing out on the opportunities to correct the system.

So, what should be done?
There is a lot of leverage in the system. We give tax subsidies to debt which is a very bad policy all over the world. What’s more, interest rates are so low that everybody is taking risks and wants to borrow just to juice up returns. But you don’t see anywhere else the intensity of the hate of equity that you see in banking. To me as a corporate finance expert this intense hate of equity is a symptom of having too little equity as a general rule. In fact, the very intense hate is a sign of insolvency. In banking, it’s this kind of zombie phenomenon: you can actually be insolvent and hide it with «good» numbers. As long as you don’t default, everything seems to be fine. Your equity is worth something in the markets because you’re too big to fail and investors don’t think they will ever be wiped out and meanwhile they get a lot of the upside.

Then again, the largest banks claim that in the process of the Basel III framework they have built up enough equity to absorb severe losses in a crisis situation.
The banks like to point out how much their equity ratios have risen since the financial crisis. But if previous equity ratios were close to zero, twice of that is still not very much. Also, how you measure equity is key; how you measure it relative to all the risks. Some of these banks have a lot of derivatives on and off their balance sheet and I don’t think we understand all the risks there. We don’t really know what all the risks are, both for the individual institution and for the system as a whole. So, it’s very hard to assess the true strengths of any of these institutions given their disclosures. I don’t know if the regulators are that much more able to assess the strength of their balance sheets with stress tests and other provisions.

What makes you so skeptical?
There are a lot of numbers you can go through. But these regulatory measure numbers which the banks are using now to say that there is so much more equity on their balance sheets than before the crisis are not that different from the old measures that wouldn’t have even told you that there is a crisis when there was one in 2008/09. Also, the banks still take a lot of risks. So as long as things are good it’s like you’re having a lot of fun driving 150 miles an hour and you only hope that you are going to make it through the next bend. That’s why I don’t take these statements to convince myself that the system is safe. I don’t see enough evidence that it’s safe. So we live in hope.

But hope is not a strategy. That’s especially true for Switzerland where the financial industry accounts for a large part of the overall economy.
The regulators I’ve met in Switzerland understand the problem of financial stability. But I’m not sure that the Swiss politicians are appreciating some of the more nuanced issues which have to do with the credibility of all these loss-absorbing debt instruments like Cocos. We know that in the financial crisis these kinds of Tier-2-instruments did not absorb the losses. There are also problems with triggering these losses. In a crisis, there is no mood for haircuts as we saw in 2008/09. Only the creditors and shareholders of Lehman lost a lot of money. Everybody else was paid with huge sums of bailout money. Even insolvent banks didn’t face the consequences of their insolvency. So, it’s really mysterious to me why people want to believe that the next time it would be different.

Then again, Switzerland decided to implement a so called «Swiss Finish» – enhanced capital requirements for systemic banks that go beyond Basel III.
It’s not just about capital regulations. What about other kinds of misconduct? What about taxes, for instance? Swiss banks did get into a lot of trouble in this area. There have been a lot of pretty harsh settlements with Credit Suisse. The fundamental question is if these banking giants have sufficient incentives to comply with the law. Too big to fail, which certainly the two big banks of Switzerland seem to be, is almost a license to be above the law. That’s because often times, the government is afraid to impose a big fine. Also, there is no way to take a corporation to jail. So the options are limited.

And what about UBS? Like many other big banks, UBS needed a bailout during the financial crisis.
UBS obviously got into severe trouble during the crisis. Therefore, it might be a good refresher for everybody in Switzerland to go back and read the unusually candid report of UBS to its shareholders about what it did before the crisis. This document, some say, should be required reading to see how UBS was just following the herd without really knowing what they were doing in the US subprime market and why they were doing it. But I’m not sure if UBS learned its lesson.

Where do you spot the biggest risk in the financial sector?
I don’t know what the biggest risk is. I get my information from the news like everybody else. But you see a lot of data breaches and a lot of indications that there are challenges there. Also, Europe has not cleaned up its banking system in general. So this was kind of Europe’s lost decade, an expression that was used about Japan in the past. It’s the amount of problems: the continued weakness of many European banks and the lack of integration in a political and regulatory way. The fragmentation in Europe is such that it exacerbates the problems of the weak banks with a lot of non-performing loans. Non-performing loans can be a threatening issue in a recession as we learned in the case of the subprime loans US borrowers couldn’t pay during the financial crisis. This is not Switzerland’s problem, it’s mostly the Eurozone’s problem. But Switzerland is right in the middle of that.