Quest for profit can make banks safer The lust for improved return on equity is providing the positive impetus for change "Capital, capital, capital," intoned Tim Geithner in 2009, as the US Treasury secretary described the best route to make the financial system safer. His wish was granted. Banks have added billions of dollars of equity capital since the crisis, whether to reassure shareholders and regulators or to comply with the new rules, known as Basel III, which raise capital requirements around the world. But a growing chorus of opinion, including from senior policy makers, asserts that the capital-raising has not gone far enough. The latest salvo comes in The Bankers" New Clothes, by Anat Admati and Martin Hellwig, two academics who have been advocating more capital for several years. Their book systematically dismantles the shibboleth that more bank equity - for example less indebtedness - will cripple the economy. Bankers" arguments, or "new clothes," confusing reserves with capital to claim that money will be "left on the sidelines," are adeptly broken down. Banks" obsession with return on equity is said to be the root of the problem: ROE is higher when profits are leveraged with debt; this makes the whole system more fragile. Perhaps more notable than the authors" arguments are those singing their praises on the back. "At last," says an exuberant Sir Mervyn King, governor of the Bank of England. Two eminent economists explain in plain English what is wrong with banks and what needs to be done to make them safer. Paul Volcker, the former Federal Reserve chairman, and other former regulators also weigh in with similar endorsements for the simple idea that more capital is needed. Veteran regulator watchers say this is unusual. The regulatory pendulum is supposed to gently swing back and forth: it should have reached its extreme point with the reforms passed since the crisis - from Dodd-Frank in the US to Basel III internationally - and now the banks should be enjoying a gradual easing. Instead, bank executives are worrying about new threats. It is not just carping from the audience of retired or retiring policy makers. The chorus in the US Congress to end "too big to fail" and break up large banks grows louder. Officials like Jeremy Stein at the US Fed and Andy Haldane at the Bank of England have all in the last year advocated more sweeping bank capital reforms. However, The Bankers" New Clothes and its eminent cheerleaders gloss over the transformation of the industry that is under way. There is far more capital in the banking system than there was in 2007. The Basel III regulations - even with capital requirements that Admati and Hellwig deem "outrageously low" - are changing behaviour in the real world. UBS, Barclays and Morgan Stanley are some of the most visible examples of banks withdrawing from risky activities. But this is happening at every large institution. Goldman Sachs revealed its "capital efficiency tool" last week, software that allows employees to measure how much capital is required by businesses or even individual products and decide whether they should be pursued. It is the lust for improved ROE - identified in The Bankers" New Clothes as a major problem - that is, in fact, providing the positive impetus for change. Banks are not able to rely on riskier activities as the capital hawks suggest. They are channelled away from them because Basel III puts tough "risk weights" on riskier businesses, increasing the capital that needs to be held there and putting downward pressure on ROE. Regulators will have to be watchful that bankers do not dream up new risky products that evade high capital charges. But the evidence seems to be in the opposite direction so far: safer businesses such as advisory work or retail brokerage are being preferred because they are "capital light" and so good for overall ROE. Yes, in theory, as Admati and Hellwig argue, investors should accept lower ROEs for less risk. At the margins this might happen. But so far shareholders are becoming more assertive and demanding higher returns. Goldman is never going to be as safe or as boring as an electric utility: investors actually want more risk and more reward. This ROE drive is also changing attitudes to bonuses, with executives such as Morgan Stanley's James Gorman unafraid to say the profit pool will be recalibrated with shareholders receiving more and bankers less. Admati and Hellwig have done a valuable service in shining light on this debate, providing the lens through which the industry can be scrutinised. But there is some hope that, happily for all of us, the bankers might not be naked after all. Tom Braithwaite is the Financial Times" US banking editor