In their important new book, “The Bankers’ New Clothes,” Anat Admati and Martin Hellwig challenge a cherished belief of people who run big banks: Equity is “expensive” and requiring banks to fund themselves with more equity (relative to their debts) will somehow slow the economy.

This is what we hear from top executives as their central argument in the pushback against financial reforms. Jamie Dimon, chief executive officer of JPMorgan Chase & Co., for example, suggested last week: “I think all banks will have too much capital in 2 ½ years. And they’re not going to know what to do with it.”

Admati, a professor at Stanford University, and Hellwig, a director at the Max Planck Institute in Bonn, are finance experts. Their book, excerpts of which were published by Bloomberg View, dissects the bankers’ claims — along with many of Dimon’s public statements — in meticulous and often humorous detail.

Their bottom line is simple: The people who run banks will always want to have less equity, because this enables them to get more upside when times are good, and they can rely on various forms of government downside support when decisions go wrong. It is very expensive for the rest of us if banks fund themselves with so much debt and so little equity, because this creates a fragile and distorted financial system that doesn’t provide reliable support to the economy.

Borrowed Funds

Equity is a way of obtaining funds. So is debt. If the bank has no sensible way to use the funds obtained from shareholders, as Dimon suggests, how can we be confident that it puts borrowed funds — such as those from depositors — to good use?

How much equity is enough? Looking historically and also thinking about the scale of potential losses that could befall financial companies, the authors recommend a range of 20 percent to 30 percent for equity as a percent of total assets. This is consistent with the way other types of companies fund themselves, because they don’t benefit from the scale of guarantees available to banks.

This statement is about total assets, not risk-weighted assets. You can measure total assets in different ways. Personally, I like adjusted tangible equity relative to adjusted tangible assets, measured according to international accounting standards, as suggested by Federal Deposit Insurance Corp. Vice Chairman Tom Hoenig. For most global big banks, this equity-to-asset ratio is between 2 percent and 5 percent.

JPMorgan (JPM), for example, expects its capital to be 9.5 percent of risk-weighted (not total) assets by the end of this year. This estimate uses the deeply flawed Basel III approach. The one thing we know about risk weights is that they are always wrong.

At the end of 2012, JPMorgan’s tangible common equity ($144.6 billion) was a little more than 6 percent of its total assets ($2.4 trillion), measured under U.S. generally accepted accounting principles. And if we adjust the bank’s balance sheet to allow for a more accurate measure of its derivative assets (and liabilities), using the Hoenig measure and data for the second quarter of 2012, its equity is only 3.12 percent of adjusted asset value. Seen this way, one of the largest banks in the world is also one of the most leveraged.

JPMorgan’s recent investor presentation stresses its supposed impending “excess capital,” yet barely mentions its true leverage.

Echoing Views

Doug Elliott, a Brookings Institution fellow who worked in finance for 20 years and who was a managing director at JPMorgan from 2006 to 2009, has issued a paper that is partly a reply to some of the points made by Admati and Hellwig, even though he doesn’t mention them by name. (Others, including Harvard University’s Ken Rogoff, a former chief economist of the International Monetary Fund, are expressing similar views.) Elliott has in some situations supported higher capital requirements, yet he seems to think that Admati and Hellwig go too far.

He concedes the theoretical high ground, which is wise. Nonetheless, he suggests that there are three main points about the real world that Admati and Hellwig fail to understand. In my assessment, Elliott is incorrect on all dimensions of the debate, and his points are refuted in their book.

First, he points out that banks obtain substantial benefits from funding with debt rather than equity. For example, interest payments on their debt are tax-deductible and there are downside guarantees that help protect creditors (and executives). But these are private benefits to the banks, paid for by taxpayers — and we should be assessing the social impact, including the cost to taxpayers and the broader economy.

The goal is, partly, to reduce the subsidies to banking, particularly the guarantees that are implicit for any financial institution that is “too big to fail.” These guarantees create moral hazard and perverse incentives more generally; they also become more valuable as the bank takes bigger risks and becomes larger relative to the economy.

No one wants their subsidies reduced. But when these subsidies create so many distortions and are dangerous — on a scale that could cause another Great Depression — cutting them becomes a pressing national priority.

Second, Elliott is concerned about transitional issues, such as what happens when banks are told to increase their equity funding. Any transition can be mismanaged, of course, but the main proposal on the table from Admati and Hellwig would prevent big banks from paying dividends or buying back shares. Instead, earnings should be retained, building up equity on the balance sheet. Nothing is being taken from shareholders because they still own this equity.

Excess Capital

Seen in this light, JPMorgan doesn’t have $28 billion of “cumulative excess capital,” as it claims, but rather an opportunity to nudge its true equity-asset ratio a little closer to 4 percent, and a little further away from the dangerous degree of leverage prevailing in the most precarious European banks.

Third, Elliott is concerned that any higher capital requirements for banks will shift more financial transactions into the “shadows.” If you police the highways, crime may move to the back alleys. As Admati and Hellwig ask: Does this mean you should give up on law enforcement? Why not patrol the back alleys, too?

Fortunately, for all its other limitations, the Dodd-Frank Act anticipated this issue by authorizing the Financial Stability Oversight Council and the Federal Reserve to extend regulation to any systemically important areas. The council’s recent push to improve the rules for money market funds is a case in point. The issue isn’t any particular fund, but rather their collective behavior and the risks they create.

Risky undertakings should be funded with sufficient equity rather than too much debt. This is how venture capital operates and how nonfinancial companies making risky bets typically fund themselves (go ask Silicon Valley).

Read the book and make up your own mind. Then send a copy to Jamie Dimon.

Simon Johnson, a professor at the MIT Sloan School of Management, as well as a senior fellow at the Peterson Institute for International Economics, is co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.” The opinions expressed are his own.