This article builds on my recent article on the keynote speech by Simon Johnson at The Political Economy of Financial Regulation conference at George Washington University. The theme of Johnson’s speech was that captured regulators are continuing to indulge in the expansion of “too big to fail” banks. To gain a better understanding of the pernicious nature of this policy, Johnson exhorted the audience to buy the book “The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About It,” by Anat Adnati of Stanford University and Martin Hellwig of the University of Bonn. For emphasis Johnson thumped the podium with a copy of the book.

On the second day of the conference, the two authors appeared on a panel titled “Financial Regulatory Reform: Politics, Implementation, Alternatives.” On several of the panels during the two-day conference, participants appeared to compete as to who could offer the most pessimistic outlook. This panel was a prime example of a mood of pessimism and alarm concerning the implications of the continued implementation of the flawed policies embodied in the Dodd-Frank Act.

Hellwig offered a European perspective on the financial crisis. He quipped that Johnson betrayed unwarranted optimism in talking about the next crisis as if the current crisis is over, but he warned that there are still a lot of “zombie” banks, and although one of them blew up in the Netherlands, there are still “quite a few more.”

He cited some banks in Germany, such as Deutsche Landesbank, that need to be wound down, but still wield considerable political influence. He criticized the German model of rescue as providing money and guarantees without exercising control over the policies of the banks. Another example he cited was banks that are exposed to the shipping industry that would be insolvent if their collateral were marked to market.

According to Hellwig, a fundamental problem in Germany and the European Union is overcapacity in banking, manifested particularly in the wholesale sector where the landesbanks operate as state-owned enterprises unique to Germany. The industry has not made necessary adjustments, and while public funding is readily available, the margins in the business are close to zero.

Hellwig characterized the policy in the European Union as “marked by forbearance and obfuscation.” His formula would be to apply the model employed by Sweden in 1992, taking control of the problem banks and putting them through resolution so that a clean bank could be restored to private control, whereas in Germany there is no control and therefore no cleanup.

The EU practice is also subject to accounting trickery that shields some assets from resolution, so that on the whole, the basic strategy is delay and lack of transparency. A private study found that collateral valuations are artificially high, which results in unrealistic loan-to-value ratios. He agreed with Johnson’s complaint that there is no system for cross-border resolution of bankruptcy claims.

Adnati followed in the same vein, offering two analogies for the behavior of bankers — that of an addict who is addicted to borrowing, and that of a trucker driving at excessive speeds with a load of explosives. Her analysis of the problem is that the banking industry is too fragile, too dangerous due to excessive leverage, too reliant on short-term debt, prone to runs, too interconnected, too opaque and so badly regulated that, “We don’t know what’s going on.”

Exposure to over-the-counter derivatives remains high, and accounting conventions masks the extent of risk. Meanwhile, debt exposure that is guaranteed by taxpayers piles up.

Adnati’s main critique was that solvency issues are falsely presented as liquidity problems that can be solved by throwing more money at the banks as regulators accommodate political pressures. Her policy prescription is a drastic increase in required capital to at least 25 percent, without netting the exposures from instruments like derivatives.