The Bankers' New Clothes: What's Wrong With Banking and What to Do About It

PREFACE
    I N THE FALL OF 2008, it seemed obvious that radical reform would be needed. For more than a year, banks and financial markets had been in a state of crisis. Then, in September, the entire financial system was about to collapse. One institution after another was failing or about to fail. Governments and central banks stopped the panic by massive interventions, but even so, the economy went into a decline of a magnitude unseen since the Great Depression.
    We hoped for a serious investigation and discussion of what had gone wrong and what would have to be done to avoid a recurrence of such a crisis. We hoped that the lessons of the crisis would be learned. But we were disappointed. There was no serious analysis of how the financial system might be made safer.
    Many claimed that they “knew” what had caused the crisis and what needed—or did not need—to be done, and they did not look any further. Bankers and their supporters argued that not much was wrong with the banking system. Serious reform, they routinely said, would interfere with what banks do and harm the economy. If we wanted banks to lend and to support growth, they wanted us to believe, we had to accept this system pretty much the way it was.
    This made no sense to us. Much of the discussion seemed to ignore what had happened. Many arguments seemed downright false. As academics who have spent our lives studying the financial system—Anat as a finance and economics professor at Stanford and Martin as an economics professor and director of a research institute in Bonn—we were shocked to see press reports and policy recommendations with misleading uses of words, flawed understanding of basic principles, fallacious and misleading arguments, and inadequate uses of mathematical models. Banking experts, including many academics, seemed to believe that banks are so different from all other businesses that the basic principles of economics and finance do not apply to them.
    We were not surprised that bankers lobbied in their own interest and said whatever might serve their needs; often their paychecks and bonuses were at stake, and the status quo worked for them. But we were dismayed—and increasingly alarmed—to see that flawed narratives and invalid arguments were not challenged but instead seemed to be winning the debate on both sides of the Atlantic. Reform efforts seemed to be stalling. Proposals were headed in the wrong direction. Simple opportunities to improve the system were being overlooked.
    We wrote about the issues, arguing for reform and exposing the invalid arguments that were being given against reform. However, important parts of the policy discussion go on behind closed doors. Even when regulators ask for public comment on a proposed regulation, most contributions come from the industry and its supporters, and additional lobbying goes on behind the scenes.
    In trying to have discussions with those involved in the debate, we discovered that many of them had no interest in engaging on the issues—not because of what they knew or did not know but because of what they wanted to know. Politicians, regulators, and others often prefer to avoid challenging the banking industry. People like convenient narratives, particularly if those narratives disguise their own responsibility for failed policies. Academics get caught up in theories based on the belief that what we see must be efficient. In such a situation, invalid arguments can win the policy debate.
    We also discovered that many people, including many who are involved in the policy discussion, do not have a sufficiently full understanding of the underlying concepts to form their own opinions about the issues or to evaluate what others are saying. The jargon of bankers and banking experts is deliberately impenetrable. This impenetrability helps them confuse policymakers and the public, and it muddles the debate.
    We are concerned about this situation because the financial system is dangerous and distorted. We have written this book to explain the issues to the broader public. We want more people to be better informed so they can form their own opinions. We want to expand the set of participants and elevate the level of the debate.
    When policymakers ignore risks, all of us may suffer in the end. A stark example was provided in Japan, where corrupted regulators and politicians colluded for years with the Tokyo Electric Power Company and ignored known safety concerns. When an earthquake