The Right Way to Control the Banks

Roger E. Alcaly
June 5, 2014 Issue

The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About It
by Anat Admati and Martin Hellwig
Princeton University Press, 398 pp., $29.95

Why, Federal Reserve Chairman Ben Bernanke asked rhetorically in an April 2012 speech, did the collapse of the trillion-dollar market for subprime mortgages set off the most severe financial and economic crisis since the Great Depression? Twelve years earlier, in 2000, the crash of high-flying technology companies such as Cisco Systems and dot-com companies such as Amazon and the now defunct Pets.com wiped out roughly $6 trillion in assets, but it set off only the relatively short and mild recession of 2001. Cisco and especially Amazon are today much larger.

The answer, now widely accepted but clearly not appreciated sufficiently at the time, is that the 2008 crisis was made possible by an extremely fragile financial system in which banks and many other businesses indulged in excessive leverage—too much borrowing—as well as hazardous reliance on short-term funding and negligent risk management, with lax regulatory supervision by the government.