FT Alphaville has just returned from the Danish Institute for International Studies" conference on central banking in Copenhagen. The theme was "central banks at a crossroads" - which we thought was particularly apt - and discussions ranged from collateral-backed finance and shadow banking to central bank independence. Indeed, many thanks to the DIIS for having us. But one presentation, we would have to say, stood out more than most; that of Anat Admati, George G.C. Parker professor of finance and economics at Stanford Graduate School of Business, who's out with a new book this month entitled "The Bankers" New Clothes." In her (controversial, to say the least) book and presentation, Admati tackles the thorny subject of bank resolution. She applies one simple recommendation: that banks should stop depending on leverage and debt for the funding of their businesses. More so, that banks should stop believing that the conventional rules of corporate finance somehow don't apply to them. Now, to any conventional banker, that sort of talk might seem silly. Err, Ms. Anat... don't you realise the whole banking business model is based on the concept of borrowing short and lending long? Take leverage away and what have you got? Full reserve banking at best, or banks reduced to the role of utilities and infrastructure providers at worst. "Ms. Anat clearly doesn't "get" banking." Having spent an hour with her on the sidelines of the conference we would wholeheartedly disagree. Ms. Anat "gets" banking, and gets it better than most. The fact that she is ruffling feather relates more to the fact that she is questioning deeply held - yet hardly ever challenged - belief systems within the industry, than any lack of understanding. Her view is best summed up in the following quote: If we want more loss absorption put up more equity! But from the point of view of the banking industry it's "anything but equity." Look back at the crisis. No-one can really deny that it was the public balance sheet, not "liquidity," that ultimately saved the day. Government capital injections and temporary nationalisations ended up being the most powerful resolution of all. As the FT's Tracy Alloway has long reported, the erosion of banks" tangible common equity became the key manifestation of the crisis upon bank balance sheets. Their inability to meet short-term liabilities was in many ways only a symptom of that underlying state of affairs. Liquidity alone would not, therefore, have been able to compensate for the capital destruction that took place on the asset side of their balance sheets. Had the central bank acquired distressed assets at the original mark-to-fantasy valuations offered up by banks - effectively pretending that no capital destruction had taken place - then perhaps you could have got around the problem. But in terms of mechanics, that would still have constituted the nationalisation of losses. It's just that the losses would have been nationalised by a central bank via money dilution (and inflation) - a move that would have unfairly distributed the pain to savers rather than debtors. And in the end, the losses - if not recovered - would have to be transferred to the government at some stage anyway. Another way of looking at it is that this would have been the equivalent of the central bank offering uncollateralised liquidity - which is against most central bank mandates due to its potentially destabilising monetary consequences. More to the point, it would have broken the rule that central banks are not supposed to lend to obviously insolvent (rather than liquidity constrained) institutions. If bad loans were relentlessly compensated for by the central bank every time they turned sour, you'd only end up with unsterilized money injection - which in itself might not be a bad thing if it was offsetting money supply contraction, but which could unleash moral hazard and de facto national banking instead. By doing a government capital injection, the losses were at least fully socialised across all members of the economy. Furthermore, a government nationalisation programme is arguably easier to unwind at a later date than the effects of unsterilised money printing. And it was definitely the full intention of the government that these nationalisations and capital injections should be of a temporary nature. So here comes Admati's major point. Bank resolution is fundamentally about transferring bank responsibility (and risk) away from the public sector and back to the private sector. It's about making the banks responsible for themselves again by weaning them off state-aid. Even though government loans have on the surface been repaid, the central bank put and the understanding that these institutions are now too big to fail, implicitly continues to provide an equity backstop. The equity risk has thus not yet really been transferred to the private sector at all. This is an important given that by this point in the cycle QE has turned into a stealth transfer of risk away from the fiscal authority over to the monetary authority. It's true that in its initial phase QE provided genuinely needed liquidity and a dealer of last resort function for securities that no-one else was willing to take. Thereafter, however, QE has really been about propping up the system with an overpriced bid (Bernanke's put option) - a fact that has led to too much liquidity in some quarters and not enough in others (the shortage of safe assets phenomenon). Indeed QE's purpose is no longer really about liquidity provision, but rather taking the interest-rate risk out of the public market while providing a supportive bid for securities still perceived to be risky (such as MBS). But even with that level of de-risking by the monetary authority, bank equity continues to underperform: This suggests that while QE has been successful at encouraging the market to take risk in some quarters of the market, it's failed dismally at persuading investors that the bank model is ever going to be a good bet - even in a less risky environment. As Admati sates, it's unsurprising that in this context banks see equity as an expensive form of funding. More so, it threatens to be dilutive and to undermine the industry's much loved return on equity (ROE) ratio. That's why the industry turned to contingent covertible capital as a resolution mechanism: it's equity funding in disguise. As Admati told FT Alphaville, from an accounting point of view, there's really very little that differentiates CoCos from equity. So why not just go direct to equity markets instead? The real answer to that, she suggests, is that if banks actually tried to raise equity funding they'd struggle. They certainly wouldn't be able to do it at current valuations. Hence the real reason equity is being disguised as leverage. Though, she points out, there are tax advantages too. Which brings us to her second point. For some reason banks sit in the grey area of corporate accounting. Analysts and equity investors openly ignore metrics such as cashflow and market cap, to over focus on book value and ROE instead. Negative cashflow, in particular, is considered irrelevant since it's seen as a byproduct of the money creation role of banks. Yet in Admati's view negative cashflows are still important since they highlight better than any other metric when too much is going out versus what's coming in. As for the current Basel consensus that "buffering up" on the capital front is somehow a real solution to the eroded equity issue, Admati notes there is a difference between capital reserves and capitalisation. In today's world an undercapitalised bank can still have reserves and appear healthy from a balance sheet perspective. This is because the equity support from the government is implicit and not clearly identifiable on the accounts. How does Bernanke's put option pop up on the balance sheet? Which means our entire approach to bank valuation may have become lackadaisical, if not entirely misjudged. Some others on the sidelines of the conference suggested that a special accounting model should perhaps be constructed for the banking sector - one that draws on both the schools of credit and accounting to understand banks" unique peculiarities. Yet the problem, dare we say, is not even that banks are borrowing short and lending or investing long, it's that they are doing so ineffeciently - thus in a way that continuously destroys capital. The need to mitigate the risks associated with this sort of duration mismatch was discussed - one suggestion was that banks should somehow downsize the duration risk - nobody really seemed to clock the implications of the conversation in hand. That is apart from Ms. Admati. The fact that borrowing short and lending long is seen as the key problem in banking, is perhaps the oxymoron of our age. What is really being inferred, after all, is that the banking model itself is dead. If it wasn't there shouldn't be any problem in raising equity. More so, that the only solution lies either in fully equitising banking or turning to a borrowing long, lending short alternative (best reflected by negative interest rates and the domain of pariah banking incentives) also misses the fundamental point. In the current environment, the only risk-free banking model is one in which banks are incentivised to destroy capital. That is not a product of the crisis, but a product of our times. There are ever fewer opportunities for real investment return because of a growing lack of scarcity in the western world. In Admati's eyes, banks which were entirely equity funded would not require any "setting aside" of funds. They would conversely be better at encouraging only productive loans to be made. If no productive ventures were to be found, then the result would be rising cashpiles - which, ironically, is what's happening anyway, even with the state as the primary (yet implicit) equity holder in banks. In an equity financed model, banks would either turn into venture capitalists - lending high risk at the right price - or remain extremely cautious, opting not to lend at all if productive loans cannot be found. Which leaves us with three important conclusions: The banking industry as it stands represents "government lending" in everything but name. Even in its implicitly state-supported form the industry is struggling to find productive loans. It's unsurprising the industry is unattractive to equity investors. Three other points to consider on the back of those: Any lending forced upon banks under government duress would likely be directed towards unproductive loans, thus the equivalent of uncollateralised money-printing. If banking remains in the private sector it should be equity funded. But if there aren't enough productive loans to be had, equity funding will simply encourage cashpiles to accumulate contracting money supply. In that scenario the government/monetary authority would have to compensate either with uncollateralised money-printing or debt-financed government spending and sterilisation through taxes, when needed. Final thought: Perhaps we're all government employees already, we just don't realise it? Second final thought: What is equity if not perpetual debt? And what is money if not national equity? Is there really any differentiation at this point? Related links: Why Bank Equity Is Not Expensive - Standford Business Pariah profits in an age of "negative carry" - FT Alphaville The negative carry universe - FT Alphaville FTAV the robot employment threat - FT Alphaville Credit Supernova! Bill Gross Pimco