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Capital Requirements

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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.