Too much self-interest in banking makes the sector dangerously fragile, exposes the public to unnecessary risks and distorts the economy, according to Anat Admati, George GC Parker professor of finance and economics at the Graduate School of Business at Stanford University in the US.

Addressing the IPE Awards Seminar in Noordwijk, the Netherlands, yesterday, she said: “There are things to do about [the failing banking system], but they may not get done, unfortunately. There is a lot of politics and a lot of confusion and a lot of self-interest in this.

”That is a governance problem, and it goes all the way to the politicians. Key to the observation is that banking is not a system, right now especially, where markets work. It requires firm and effective regulation, sensible regulation.”

The root cause of the problem is that banks hold a lot of leverage, unborrowed funding, with the loss-absorbing equity ratio on their balance sheets being too small.

“The credit crunch did happen not because they had too much equity but because they had too much debt,” she said. “Banks make bad lending decisions – too little or too much, boom and bust or too much and too little at the same time.”

She added that, “even now, the continued weakness and distorted incentives of banks dampen new lending that would help economic recovery”.

Instead of the small amounts of equity banks currently hold – around 5% – Admati suggested they ought to hold an equity ratio of 20-30%.

Holding more equity is not expensive she said.

In addition, some of the risks taken in the current banking sector, such as excessive leverage risks, benefit only the very select few – while many will suffer.

And while regulators have authority, she accused them of lacking the political will to change things.

Admati believes some banks may no longer be viable.

In the preface for her book ‘The Bankers’ New Clothes’, published earlier this year, she writes: “A cleanup of such banks and of the financial system is important even if it means eliminating or shrinking some banks.

”Hiding from reality and providing public support to banks that cannot otherwise survive or which are too big and too complex to control, as governments all over the world are doing, is dangerous and expensive.”

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