11/12/2010 10:27 am ET | Updated May 25, 2011

Vikram Pandit Has No Clothes

Vikram Pandit heads Citigroup, one of the world's largest and most powerful banks. Writing in the Financial Times Thursday morning, with regard to the higher capital standards proposed by the Basel III process, he claims

There is a point beyond which more is not necessarily better. Hiking capital and liquidity requirements further could have significant negative impact on the banking system, on consumers and on the economy.

Mr. Pandit is completely wrong. To understand this, look at the letter published in the Financial Times earlier this week by finance experts from top universities -- the kind of people who trained Mr. Pandit and his generation of bank executives.

The professors write,

Basel III is far from sufficient to protect the system from recurring crises. If a much larger fraction, at least 15%, of banks' total, non-risk-weighted, assets were funded by equity, the social benefits would be substantial. And the social costs would be minimal, if any.

The point is that "bank capital" just reflects the choice between debt and equity -- to "have more capital" simply means to rely more on equity relative to finance. From the professors again, and remembering that these people also have a great deal of practical experience,

High leverage encourages excessive risk taking and any guarantees exacerbate this problem. If banks use significantly more equity funding, there will be less risk taking at the expense of creditors or governments.

Bankers warn that increased equity requirements would restrict lending and impede growth. These warnings are misplaced. First, it is easier for better-capitalized banks, with fewer prior debt commitments hanging over them, to raise funds for new loans. Second, removing biases created by the current risk-weighting system that favor marketable securities would increase banks' incentives to fund traditional loans. Third, the recent subprime-mortgage experience shows that some lending can be bad for welfare and growth. Lending decisions would be improved by higher and more appropriate equity requirements.

Mr. Pandit is a smart individual and he knows all this -- he has a Ph.D. in finance from Columbia University. Why then does he advance such obviously specious arguments in the pages of the Financial Times?

The answer is straightforward.

a) He can get away with it. Modern financial CEOs float in a cloud above the public discourse; they can spout nonsense without fear of being contradicted directly in the pages of a leading newspaper.

b) Officials listen to bank CEOs and an op ed gets their attention. Perhaps they think Mr. Pandit knows what he is talking about -- or perhaps they know that these arguments are completely specious. In any case, they are deferential.

c) Mr. Pandit is communicating with other CEOs and, in this fashion, encouraging them to take recalcitrant positions. There is an important element of collusion in their attempts to capture the minds of regulators, politicians, and readers of the financial press.

Mr. Pandit is engaged in lobbying, pure and simple. Ask the people who invented modern finance theory and figured out how it should be applied (second to last paragraph),

Many bankers oppose increased equity requirements, possibly because of a vested interest in the current systems of subsidies and compensation. But the policy goal must be a healthier banking system, rather than high returns for banks' shareholders and managers, with taxpayers picking up losses and economies suffering the fallout.