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

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

http://dx.doi.org/10.1257/jel.52.1.197

197

1.  Introduction: A Book Worth Comparing 

to Keynes’s General Theory 

W

e expected that the Great Recession 

after 2007 would yield major written 

responses that should be worthy of such 

global attention as Keynes’s General Theory 

received in 1936.  The Banker’ New Clothes: 

What’s Wrong with Banking and What to Do 

about It by Anat Admati and Martin Hellwig 

is such a book. Admati and Hellwig have 

written a book for the general public about 

fundamental problems of financial instabil-

ity in our time. They have used their com-

mand of economic theory to identify one 

*

 

University of Chicago. The author is greatly indebted 

to Jeremy Bulow, John Cochrane, Milton Harris, and 

Douglas Levene for detailed comments that substantially 

improved this paper.

† 

Go to http://dx.doi.org/10.1257/jel.52.1.197 to visit the 

article page and view author disclosure statement(s).

key central issue that informed citizens need 

to understand: banks should be required to 

have much more equity.

Banks are vital financial institutions that 

channel millions of people’s savings into 

credit for economic investments. In particu-

lar, banks get substantial funds from depos-

its which, as debts of a bank, are supposed to 

have such a clear and safe value that everyone 

should accept them as equivalent to any form 

of cash. Such power over the investment of 

other people’s money can entail regular temp-

tations to abuse the depositors’ trust, however. 

Small businesses and other borrowers who 

rely on banks for credit implicitly depend on 

bankers’ ability to maintain depositors’ trust, 

but small depositors cannot be expected to do 

all the necessary work of monitoring to certify 

that their banks are trustworthy. So there is an 

essential role for public regulation of banks: 

to maintain stable trust in channels of credit 

that are vital to our society.

Rethinking the Principles of Bank 

Regulation: A Review of Admati and 

Hellwig’s The Bankers’ New Clothes

†

Roger B. Myerson*

In an important new book, Anat Admati and Martin Hellwig raise broad critical 

questions about bank regulation. These questions are reviewed and discussed here, 

with a focus on how the problems of maintaining a stable financial system depend on 

fundamental problems of information and incentives in financial intermediation. It is 

argued that financial regulatory reforms can be reliably effective only when their basic 

principles are understood by informed citizens, and that Admati and Hellwig’s book 

is a major contribution toward this goal, as it clearly lays out the essential case for 

requiring banks to have more equity. (JEL G01, G21, G28, G32, L51, M48)

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

198

But the vast wealth involved in the bank-

ing business is more than enough to poten-

tially corrupt any small group of officials, so 

the reliability of any regulatory system must 

depend on broad public monitoring of the 

regulatory process itself. Regulators’ rulings 

must be based on public information accord-

ing to principles that informed citizens can 

understand, so that public officials can be 

held accountable for any failure to regulate 

appropriately, even when a major crash does 

not result from this failure.

Thus, any meaningful financial regulatory 

reform must include a clear explanation of 

its principles to millions of informed citizens 

and investors. Admati and Hellwig’s new 

book can fill that essential role. Other excel-

lent books should also be recommended 

(see Goodhart 2009; Dewatripont, Rochet, 

and Tirole 2010; Schooner and Taylor 2010; 

Kotlikoff 2010; Duffie 2011; Barth, Caprio, 

and Levine 2012; and Gorton 2012), but 

Admati and Hellwig have matched broad 

clarity of exposition with a carefully cho-

sen focus that deserves the widest public 

readership.

2.  Why Banks Should Be Required to 

Have More Equity

The core message in this book is that banks 

should be required to have more equity.  A 

bank’s equity is its owners’ stake in the bank’s 

investments. This equity value also called the 

bank’s  capital. The value of this equity can 

be computed by adding up the values of all 

the assets or investments that the bank owns, 

then subtracting the values of all the debt 

liabilities that the bank owes to its depositors 

and other creditors. The difference is the 

value of the equity or capital that belongs to 

the bank’s owners.

Admati and Hellwig introduce these ideas 

with a story about a person named Kate 

who is buying a house, partly with her own 

money and partly with money borrowed in 

a mortgage. The part that Kate bought with 

her own money is her equity or capital in 

the house. For a house of any given current 

value, if Kate put more of her own capital 

into the purchase price, then the mortgage 

lenders would bear less risk of the house’s 

value falling below the amount owed in a 

default, and so they should be willing to lend 

to Kate at a lower interest rate. In such a sit-

uation, Kate may well feel that contributing 

more capital could actually make her house 

investment less expensive. But when Kate’s 

rich Aunt Claire offers to sign a loan guaran-

tee, suddenly Kate can get a low interest rate 

on the mortgage loan that will not depend on 

the amount borrowed. Then Kate may begin 

to see equity as an expensive way to finance 

her house, and she may have an incentive 

to borrow as much as she can, investing her 

own money elsewhere. But borrowing more 

is implicitly transferring more risks to Aunt 

Claire, who must pay the guaranteed amount 

if the house’s value falls and Kate defaults on 

the loan. So Aunt Claire should not sign a 

loan guarantee without specifying some 

lower bound on how much Kate has to con-

tribute to the price of the house. This is the 

basic logic of equity regulation, except that 

Kate becomes a bank owner and Aunt Claire 

becomes the taxpaying public.

Admati and Hellwig report that, early 

in the twentieth century, banks typically 

had equity capital worth about 25 percent 

of their total assets. That is, each dollar 

invested by such banks included twenty-five 

cents that actually belonged to the bank’s 

owners, along with 75 cents borrowed from 

depositors and other creditors. If the value of 

the bank’s assets were to decline, the losses 

would be borne by the owners, with no affect 

on the bank’s ability to repay its depositors, 

until the owner’s equity was exhausted. So, 

a large value of equity was needed to reas-

sure depositors that the bank was very likely 

to be able to repay them. Without this reas-

surance, they would not have been willing to 

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