Volume 66, Issue 5, 1161-86
Suppose a woman named Kate wants to start a bank. She has $5 of her own and knows a creditworthy entrepreneur (Will) who needs a $100 loan for a new project. She also knows lots of people who would happily deposit their savings with her. Should regulators permit Kate’s bank to borrow (from depositors) the extra $95 she needs to lend to Will? Or should it require her to borrow less and put up more of her own money before extending the loan? How much does it matter to financial stability?
Two superb accounts of the 2007–2008 financial crisis and subsequent reform efforts provide very different answers to these questions. Gary Gorton’s Misunderstanding Financial Crises is part of an influential line of papers and books that has placed him on former Federal Reserve Chairman Ben Bernanke’s recommended syllabus for those seeking a deeper understanding of the crisis. The Bankers’ New Clothes, by Anat Admati and Martin Hellwig (“A&H”), has been praised by luminaries across the political spectrum, and lauded by an economics Nobelist as worthy of comparison with John Maynard Keynes’s General Theory. Gorton and A&H agree that the financial system remains dangerously vulnerable five years after the worst of the crisis in the United States, and that reform efforts such as the Dodd-Frank Act and the Basel III Accord do little to address the fundamental problem. Their diagnoses and prescriptions, however, differ markedly. . .