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.1

That there is wide agreement on the causes of the crisis should not be surprising. It is hardly novel to recognize, for example, that short-term borrowing can be quite precarious during a crisis when lenders become cautious and loans that come due cannot be renewed. This forces the borrowers to sell assets, further depressing asset prices and deepening the collapse, a chain reaction that propels severe crises.

The basic problem, however, was not ignorance of such dangers, but that federal and state regulators in the mid-2000s were not sufficiently vigilant in anticipating and controlling them.2 Awareness of these failures has still not been translated into adequate legislation and new regulations. The banks were allowed to run wild by those charged with regulating them—particularly in borrowing imprudently and in acquiring and creating soon-to-be-worthless mortgage-related securities. The Federal Reserve, led by Alan Greenspan and Bernanke, should have been questioning and restraining these practices. It did not do so, and too little has been done to make another crisis much less likely to happen.

The regulatory failures in the buildup to the recent crisis were induced by the same complacency that infected the financial system and economy in the latter stages of the period economists call “the great moderation,” beginning in the early 1980s and spanning roughly two decades of relatively steady growth and low inflation, interrupted only by recessions that were short and mild.3

Similarly, the tepid recovery from the 2007–2009 “great recession,” although very modest compared to others, has allowed politicians and regulators to yield to intense lobbying and legal challenges launched by the financial industry to chip away at proposed reforms. Particularly unfortunate are the failings of the Dodd-Frank legislation. Too complex and yet too vague, it offers countless opportunities for lobbyists to weaken or exploit its provisions. Lobbying pressures were evident in the prolonged negotiations among the five regulators responsible for writing the Volcker Rule, which prohibits banks from trading for their own accounts. (The regulators consist of the Federal Reserve, the…