Sept. 3 (Bloomberg) -- Every age has great debates on its defining questions. Sometimes these disputes are on a grand scale: capitalism versus communism. Sometimes they concern details that puzzle later generations: Summarize the main points of contention in the Thirty Years’ War, without consulting Google.
The defining conflict of our time is over what might seem to be a relatively arcane and technical detail: leverage, meaning the extent to which financial institutions should be allowed to borrow relative to their total balance sheets. The question won’t be decided on the battlefield, in the courts or by the public. The Board of Governors of the Federal Reserve System will make the call.
There are plenty of other important debates taking place around the world, but these questions are largely settled, and many of the issues are more rhetorical than real. Sure, China runs a mixed economy, but it combines plenty of state meddling with a vibrant private sector. France imposes higher taxes on rich people, but have you seen how well those elite live? And the top 1 percent is doing well everywhere, from Russian oligarchs to Silicon Valley moguls. Convergence in economic models is the order of the day.
Except when it comes to the question of how much bank leverage is too much. On this issue, there are two equally determined -- and irreconcilable -- camps. The stakes are high; excessive leverage could bring down the world economy again. And the next financial collapse could be even worse than what we experienced in the fall of 2008 and the prolonged recession that followed.
What separates the two sides is a well-defined bone of contention: the extent to which banking regulators should rely on a simple leverage ratio -- that is, the size of banking assets relative to loss-absorbing equity capital, with due (or perhaps any) consideration of so-called risk-weighted assets.
In one corner, we have the world’s banking elite, whose latest champion is Peter Sands, the chief executive officer of Standard Chartered Plc. “I guarantee that a regulatory framework that uses the leverage ratio as a primary measure will make banks and the banking system more prone to crisis,” he wrote recently in the Financial Times.
Because Sands calls the shots at a bank that is big enough to cause a global panic were it to get into trouble, we should take him seriously on this point. Perhaps we should even regard his words as signaling a willingness to take the kind of risks that threaten to bring down the financial system -- and would force the U.K. government, and perhaps others, to step in with rescue packages.
It isn’t by chance that some version of Sands’ words can be heard from almost every executive at a “too big to fail” global bank: They want to be able to take more risks precisely because they can draw on implicit or explicit government guarantees. When these companies increase their loss-absorbing equity to reduce their leverage, as Deutsche Bank AG and Barclays Plc are now being pressured to do, executives scream about how this will hurt the real (read: nonfinancial) economy. Never mind the evidence that banks with “higher and better-quality” capital were better able to keep lending during the 2007-2009 crisis (see “Balance Sheet Strength and Bank Lending During the Global Financial Crisis,” a recent International Monetary Fund working paper by Tumer Kapan and Camelia Minoiu).
Arrayed against the world’s big banks are some of the sharpest financial intellects, including Tom Hoenig, vice chairman of the Federal Deposit Insurance Corp. and author of “Basel III Capital: A Well-Intended Illusion,” which explains why the risk weights preferred by Sands are a dangerous fantasy.
“All of the Basel capital accords, including the proposed Basel III, look backward and then attempt to assign risk weights into the future,” Hoenig writes. “It doesn’t work.”
By contrast, he says, a properly defined leverage ratio “provides a simpler, more direct insight into the amount of loss-absorbing capital that is available to a firm.”
The risk weights on assets are always wrong. You only need to think back to mortgage-backed securities and euro-area sovereign debt, or look ahead to the approaching train wreck for some emerging markets. Letting banks calculate their own risk weights or develop their own methodologies makes no sense -- conflicts of interest predominate when you are too big to fail. But asking rating companies or government officials to come up with meaningful risk weights also is doomed to fail. They lack the information, motivation and compensation incentives to do this right.
By contrast with earlier eras, ours is a technocratic age: Our debate concerns bank capital and the extent to which financial-sector executives who run megabanks should be allowed to gamble, even when they get the upside and the downside is someone else’s problem, with this asymmetry exacerbated by leverage.
The right historical analogy is the U.S. debate over antitrust laws at the beginning of the 20th century. Many people deserve credit for pushing this issue to the fore, notably President Theodore Roosevelt, who brought a case against J.P. Morgan’s Northern Securities Co. The matter was ultimately decided in the government’s favor by the U.S. Supreme Court, in a 5-to-4 decision in 1904. That ruling spawned further cases, legislation and, eventually, a big shift in public opinion.
Had the monopolists won, instead of enjoying a vibrant competitive economy and a century of unprecedented growth that made the U.S. the world’s greatest power, we would have ended up much like other countries where a few businessmen are too powerful: a bigger and more northerly banana republic.
Recently, the Fed’s Board of Governors agreed -- under some pressure from the FDIC, among others -- to consider putting more emphasis on leverage ratios. Sands and his colleagues are pushing back -- just as Morgan pushed back against Roosevelt.
Will the Fed stand with Hoenig and many others to defend the public interest? Or will the central bank do what four members of the Supreme Court wanted to do in 1904 and side with the very powerful?
(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.”)
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