Journal of Economic Literature 2014, 52(1), 197-210



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207

Myerson: Rethinking the Principles of Bank Regulation

were to materialize. At this point the bank-

ers can tell themselves: officially these assets 

are safe, and if not, then we will be bankrupt 

anyway, so why not borrow more and invest 

more to earn even greater profits in the likely 

event that all the worriers are wrong? Then, 

when the unlikely risk actually does material-

ize, it can bring down a large portion of the 

banking system. We have seen such a process 

unfolding at least twice in the past decade, 

once for AAA-rated mortgage-backed secu-

rities in America, and then again for sover-

eign debt in the euro zone.

Indeed, the current problems of the euro 

zone should be understood in the context 

of the Basel approach to capital regulation. 

At the beginning of the Basel process in the 

1970s, the first concern was to make sure that 

foreign currency risks were adequately taken 

into account in bank regulation (see Goodhart 

2011). Also, almost from the beginning of 

the Basel process, governments called for 

regulatory standards that would encourage 

banks to hold their sovereign debt. This bias 

to ignore risks of sovereign government debt 

in its own currency was not revised when the 

sovereign nations in the euro zone lost the 

ability to print their own currency. Thus, the 

creation of the euro zone converted large 

debts between European nations from a risk 

category that bank regulators were directed 

to particularly scrutinize into a category that 

bank regulators were directed to ignore. This 

illogic of bank regulations has been funda-

mental to recent crises of the euro zone.

The risk-weighted capital adequacy sys-

tem may have harmed the economy in other 

ways.  Well-rated marketable securities were 

given lower risk weights than loans to indi-

viduals or small businesses.  This incentive to 

shift banks away from lending to individuals 

and small businesses would become particu-

larly acute when bank capital became scarce 

in the financial crisis, and the resulting loss 

of credit for small businesses would increase 

unemployment thereafter.

Moves to bundle and repackage small 

loans into marketable securities may have 

been substantially motivated by the incentive 

to convert these assets into a category with 

lower risk weights. But in the financial cri-

sis, enthusiasm for such securitization waned 

when it was found to exacerbate moral haz-

ard in lending standards. More broadly, we 

should ask how much of recent financial 

innovation has been motivated by the goal of 

exploiting regulatory loopholes, which effec-

tively encouraged banks to enter a network 

of complicated transactions that could make 

the allocation of risks harder to trace.

Rules that allow equity requirements to 

be based on the banks’ own models for risk 

management add another layer of complex-

ity against any hope of public validation of 

regulators’ decisions. Furthermore, these 

rules can effectively reward banks for using 

models that understate their own risks, which 

raises the serious danger that senior manag-

ers could deliberately blind themselves to 

some portion of the risks that their organiza-

tion is bearing. 

In the search for a basic statistical bench-

mark for evaluating when equity is sufficient 

to assure that owners have appropriate incen-

tives to avoid risks of failure, it may be help-

ful to consider data about the size of public 

losses from failed banks as a fraction of their 

deposit liabilities. American banks that failed 

during the decades from 1978 to 2007 gen-

erated public losses that averaged about 19 

percent of deposits, according to the FDIC’s 

historical statistics on banking.

5

 One could 



argue that, when a bank’s equity as a fraction 

of deposit liabilities is less than this average, 

the public would statistically expect to lose 

more from the bank’s failure than its owners, 

and so greater public oversight of the bank’s 

investments may then be appropriate.

Accessed from http://www2.fdic.gov/hsob/selectrpt.



asp?entrytyp=30 on July 17, 2013.


Journal of Economic Literature, Vol. LII (March 2014)

208


6.  Other, More Radical Solutions?

 Admati and Hellwig argue persuasively 

for requiring banks to have equity worth at 

least 20 percent of assets, but a reader should 

ask, why stop there?  What goes wrong with 

the argument for requiring X percent equity 

as X percent approaches 100 percent? One 

answer is that people have a real demand 

for bank debt, because monetary-denomi-

nated deposits serve as the basic medium of 

exchange in the economy. Bank accounts are 

money that people can use to pay for gro-

ceries, but shares of stock in a bank are not. 

People agree to make transactions in dollars 

or whatever the accepted legal tender of our 

country is, and we need to make these pay-

ments in some liquid asset that has a clear 

reliable value in these units. Checking and 

debit accounts in reliable banks provide this 

vital service for our economy, and so banks’ 

issues of safe debt can provide real eco-

nomic value.

This basic point of monetary theory raises 

some difficulties for Admati and Hellwig’s 

argument, however, as the use of bank debt 

as a medium of exchange provides a fun-

damental reason why people may be will-

ing to hold bank debt with a lower rate of 

interest. It implies that a system of financial 

intermediation that financed investments 

only by equity might indeed have a higher 

cost of credit than one which issued some 

form of liquid debt. We should admit that 

going to 100 percent equity financing would 

be going too far. There is a real transac-

tions demand for bank debt, but the price 

that people are willing to pay for it should 

decrease as its supply increases. Once the 

banks’ fraction of debt financing is large 

enough to meet people’s basic demand for a 

medium of exchange, then presumably any 

further increase in debt financing would not 

elicit substantially more savings at any given 

overall expected rate of return for the aver-

age investor.

On the other hand, as Admati and Hellwig 

have emphasized, there is a real moral-

hazard cost to banks’ issue of debt, as it can 

generate incentives for inefficient risk taking 

by banks. But marginal moral-hazard costs 

of debt should be small when the amount 

of equity is large enough to keep the risk of 

insolvency negligible. So we may hope to 

find a broad range of possible equity require-

ments that would generate enough bank debt 

to meet people’s basic transactions demand 

for deposits, but would also maintain enough 

bank equity to assure that the owners of a 

bank will expect to bear virtually all of its 

investment risks.

Within this broad range, the Modigliani–

Miller argument could affirm that marginal 

changes in the fraction of equity financing 

would not significantly affect total costs of 

credit.  But to make an effective regulatory 

system, we need to specify some required 

fraction. It seems reasonable to argue that 

Admati and Hellwig’s recommended stan-

dards of 20–30 percent equity may be in this 

range, while current regulatory standards 

may be substantially below it.

A related idea that Admati and Hellwig 

might have usefully discussed further is the 

narrow-banking proposal that was advo-

cated by Henry Simons, Frank Knight, and 

Irving Fisher in the 1930s. Under narrow 

banking, as described by Fisher (1935), all 

bank accounts that could be used as money 

(such as checking accounts and debit 

accounts today) would have to be backed 

100 percent by reserves of cash or deposits 

at the central bank. Fisher argued that this 

narrow-banking rule would have prevented 

the large fluctuations in the money supply 

that he saw as a factor in causing the Great 

Depression.

But this argument raises a fundamental 

question about how waves of bank failures 

could cause macroeconomic downturns. 

Would the effect occur through a contraction 

of the money supply, or through a disruption 



209

Myerson: Rethinking the Principles of Bank Regulation

of credit channels? The recent recession did 

not involve any great monetary contraction, 

but the shock to the banking system strongly 

affected the supply of credit to individuals 

and small businesses that depend on bank 

loans. Under Fisher’s original narrow-bank-

ing proposal, bank loans would depend on 

funds from savings accounts, which would 

have remained vulnerable to runs and insta-

bility when banks are weak.

Thus, when we focus on the need to main-

tain stable channels of credit, such narrow-

banking proposals seem less persuasive. The 

distribution of credit must depend substan-

tially on financial intermediaries that develop 

special expertise in the various sectors of the 

economy. The Myers–Majluf adverse infer-

ence provides a fundamental reason why 

such firms with special information may, in 

the absence of regulatory constraints, regu-

larly choose to finance investments by issu-

ing more debt instead of equity. But if many 

of these firms become excessively indebted 

and fail, then those who depended on them 

for credit will also suffer and real productive 

investments that they should have financed 

will be lost in the years that it takes to rebuild 

a strong financial system. Thus, as Admati 

and Hellwig argue (in footnote 28 on p. 271), 

narrow banking would not eliminate the 

problem that non-deposit-taking financial 

institutions might become too important to 

fail. The public interest in maintaining credit 

channels provides a basic rationale for equity 

requirements. Kotlikoff’s (2010) modern 

extension of the narrow-banking idea com-

bines it with a requirement of equity financ-

ing for financial intermediaries that make 

risky investments.

7.  Conclusions

In response to all their arguments against 

the increasingly complex provisions for mini-

mizing banks’ capital requirements, Admati 

and Hellwig report (p. 182) that they have 

never received a coherent answer to the 

basic question of why banks should not have 

equity levels between 20 and 30 percent 

of their total assets. They recommend that 

banks should be restricted from paying prof-

its to stockholders until their equity value is 

above 20 percent of assets.

This recommendation is simple, but it is 

based on their deep command of theory.  

The book is long, with many footnotes, 

because it takes time to rebut all the bankers’ 

arguments that society would suffer some 

substantial loss of economic growth if such 

a fraction of economic investments were 

financed by equity instead of debt. A bank 

may incur some real cost from equity financ-

ing, but it is primarily due to the fact that an 

increase of equity will transfer to the bank’s 

owners a larger share of the bank’s risks, 

which otherwise with debt financing might 

be passed on to creditors or taxpayers. To all 

the complex schemes for encouraging banks 

to manage risks prudently with less equity

the appropriate response is that requiring 

more equity is itself the single most effec-

tive way to ensure that a bank’s owners have 

an incentive to manage its risks prudently. 

If more regulatory control of risk is needed, 

it can be achieved by basic diversification 

guidelines that prevent the bank from lend-

ing too much to a narrow group of favored 

borrowers.

I have suggested that it might be better to 

define equity requirements, instead, as a frac-

tion of debt liabilities, to put the focus on the 

part of the balance sheet that actually makes 

equity necessary. A capital requirement of 

20 percent of assets would correspond to 

25 percent of debt liabilities. Talking about 

liabilities instead of assets has the virtue of 

moving the discussion as far as possible from 

any question of offering lower risk-weights 

for some approved assets. Instead, we could 

appropriately consider questions about 

whether the equity requirement should be 



Journal of Economic Literature, Vol. LII (March 2014)

210


on the excess of debt liabilities over cash 

reserves, or whether long-term debt should 

have a lower equity charge than short-term 

debt and deposits. Accounting standards and 

regulatory policies that prevent liabilities 

from being netted or hidden off the banks’ 

balance sheets may be essential to effective 

regulation. 

Bank regulation is obviously a complex 

technical matter, and we need to rely on spe-

cialists for the tasks of daily monitoring and 

stress tests in a crisis. But if nobody outside 

of the elite circles of finance can recognize a 

failure of appropriate regulation, then such 

failures should be considered inevitable. 

We may want our country to have a banking 

system that can reliably attract savings from 

people all over the world, and that can then 

channel those savings into loans that will 

help build the homes and businesses of our 

communities. Ultimately, in a democratic 

nation, the whole system must depend on 

informed citizens having some basic under-

standing about what bank regulators are sup-

posed to do.

So financial regulatory reforms are incom-

plete until somebody can explain to the gen-

eral public what the new rules are, at least 

well enough so that our officials can be held 

publicly accountable for implementing them.  

Professional economists can contribute to 

such reforms by articulating their essential 

principles and laying out their logical argu-

ments as simply as possible.  In this regard, 

Anat Admati and Martin Hellwig have done 

an enormously important service in this 

book. But economics professors cannot do 

it alone. Political leadership is also needed 

to get the public’s attention and communi-

cate the new principles by which the public 

should judge its financial institutions, regula-

tors, and politicians.

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New Clothes: What’s Wrong with Banking and What 

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Barth, James R., Gerard Caprio, Jr., and Ross Levine. 

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Bruner, Robert F., and Sean D. Carr. 2007. The Panic 

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Modigliani, Franco, and Merton H. Miller. 1958. “The 

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Schooner, Heidi Mandanis, and Michael W. Taylor. 2010. 

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