Archimedes knew it, and so do banks: leverage increases power. Banks don’t use sticks or poles — for them it means using borrowed money to make bigger investments than they could otherwise. Almost all financial transactions involve some form of leverage, like the mortgage that lets families use a small down payment to buy a house. When markets are going up, bets made with lots of borrowed money make bigger profits. When markets or housing prices fall, that debt multiplies losses. Through history, that math has been at the heart of almost every financial crisis, and the meltdown in 2008 was no exception. How soon we have another one may depend in large measure on whether leverage at banks can be kept within safe limits.
More than six years after an international agreement that banks needed a bigger cushion, banks are still fighting provisions that have produced deep splits among regulators as well. In 2010, regulators meeting in Basel, Switzerland, more than doubled requirements for capital ratios, the amount of shareholder equity banks need to hold for a given amount of assets, adjusted for how risky they are. That figure will rise to 7 percent by 2019, or as high as 10.5 percent for U.S. banks considered systemically important. The wrangling has focused on what goes into the cushion — how to count equity and how to count assets. That’s more complicated for banks than for homeowners, and the Basel regulators worried that banks would finesse too complex a system. The EU and Japan have split with the U.S. over proposals that would limit banks' use of their own models to adjust risk, saying that could damage weaker banks, especially in Germany and Italy. The Basel rules already include a broader, simpler accounting of a bank’s assets, called a leverage ratio, and set it at 3 percent. U.S. regulators came up with a leverage ratio of 5 percent. In the U.S., a top House Republican has proposed freeing banks from a wide range of rules if they voluntarily raised billions of dollars to put their leverage ratio over 10 percent.
Historically, banks funded their business with much more equity than they do today. Shareholder capital made up more than 50 percent of U.S. banks’ liabilities in the 1800s. In early 1900s, the ratio was about 20 percent. Through the next 100 years, it kept shrinking. Deposit insurance made such big cushions seem unnecessary. And banks gradually shifted to be less reliant on shareholder money and more on deposits and short-term cash from money-market funds. By the time the subprime crisis broke, U.S. banks’ capital was on average down to 4 percent of assets. And the largest banks’ capital ratios were even smaller — they had been allowed to assess their risks themselves, which turned out to be an invitation to use sophisticated formulas and complicated accounting gimmicks to make their balance sheets seem much smaller and safer than they actually were. When the markets crashed, many of the banks would have been insolvent but for the hundreds of billions of dollars pumped in by governments in the U.S., U.K. and Europe.
Banks say they agree with the idea of leverage limits but have resisted many specific proposals. Whether or not over-leveraging caused the financial crisis, they say, its aftermath is a bad time to introduce tighter requirements. Meeting the new rules means higher costs of funding for banks, and that could lead them to do less lending, to the detriment of economic growth. The banks especially dislike the leverage standards, because they ignore the banks’ internal models for determining which investments are riskier; they say they’ll in effect be penalized for holding on to safer assets like Treasuries. Some critics, including former U.S. Federal Reserve chairman Alan Greenspan, think that the only true long-term protection is a set of capital requirements far tougher than those proposed by regulators in Basel or the U.S. But Fed officials hope that creating especially tough requirements for the biggest or more complex banks can lead to smaller and simpler ones.
The Reference Shelf
- Excerpt from “The Bankers’ New Clothes,” by Anat Admati and Martin Hellwig, arguing that more bank capital is good for financial stability.
- Bloomberg News article on the fight over defining leverage.
- Federal Deposit Insurance Corp. Vice Chairman Thomas Hoenig has advocated tougher, simpler leverage rules.
- In a National Bureau of Economics paper “This Time Is Different” (later expanded into a book), Carmen Reinhardt and Vincent Rogoff recount how leverage has been at the heart of every financial crisis.
- Alan Greenspan interview on “The Daily Show With Jon Stewart” in which he called for far higher capital ratios.
First published March 24, 2014
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