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FinReg's killer app

"Capital requirements" are one of those terms that wonks are suddenly using a lot and that plenty of people are probably still confused by. But they're important to understand, because they're the killer app of financial regulation. David Leonhardt offers an exceptionally clear explanation:

One good way to understand the importance of capital is to look at the fate of firms that entered the crisis with relatively thick cushions. In 2007, commercial banks had an average leverage ratio of about 12 to 1, according to a recent report by McKinsey & Company. This means the banks had a dollar in assets for every $12 in debt. That was enough for many of them, like Bank of New York, to survive the bust in decent shape. In Canada, financial firms had an average ratio of about 18 to 1, and Canada endured the crisis better than perhaps any other rich country.

By contrast, the five big investment banks in this country — Bear Stearns, Goldman Sachs, Lehman, Merrill Lynch and Morgan Stanley — were close to or exceeding a ratio of 30 to 1. Of the five investment banks, Lehman collapsed, Bear and Merrill were sold at cut-rate prices and Goldman and Morgan Stanley might not have survived without government aid.

The crisis has made Wall Street much more conservative. But this will not last. It never does. Left to their own devices, financial firms will again take on big debts and big risks. They have a lot of incentive to do so. A Wall Street Journal analysis found that if one set of stricter leverage standards had been in place during the five years before the crisis, it would have reduced the biggest firms’ profitability by almost 25 percent.

Capital requirements do three things: First, they limit the amount of risk-taking that large banks can do, as they have less money to play around with. Second, they make it likelier that if the banks do take risks that go bad, they have enough money to bail themselves out. Third, they hold down the size of the bank (and its interconnectedness): A firm with billions in assets that are leveraged at 18 to 1 is of less importance to both the economy and to other banks than that same firm leveraged at 50 to 1, as the firm at 50 to 1 is both bigger and borrowing a ton of money from other banks, so their failure represents a bigger threat to both the economy and the other players in the financial system.

By Ezra Klein  |  March 29, 2010; 11:00 AM ET
Categories:  Financial Regulation  
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Next: Think Tank: FinReg edition

Comments

Seriously, if we didn't learn the importance of capital requirements from It's a Wonderful Life, we're never going to learn. If the Bailey Building and Loan had kept more capital on hand, George never would have had to spend all his honeymoon money on keeping it in business.

Capital requirements are an increasing rarity in government regulation: simple, straight forward, common sense, not flashy, not too-clever-by-half, and they work. In my humble opinion, leverage ratios of 18 to 1 are too high. But at the very least, they shouldn't be any more.

And what about ratings? Investments from banks with super high leverage ratios should automatically be rated as garbage. Because that's a pretty good bet.

Posted by: Kevin_Willis | March 29, 2010 11:05 AM | Report abuse

I understand the need to reign in the super banks with higher capital requirements. But isn't there a very real cost to our economy as a whole?

In other words, it seems that these banks benefit our economy by stretching the debt/capital ratio as much as is reasonably possible, thus (I think) increasing the "velocity of money" (the most difficult concept I have ever tried to wrap my brain around), and thus increasing our GDP.

If the amount these banks are permitted to loan is reduced by nearly half, won't the dry up a sizeable amount of money flowing through our economy?

In other words, can you make an argument that bailing out these banks every 20-30 years is a reasonable price to pay for the amount of money they send whizzing through our economy? It seems like people (perhaps rightly) focus on the recent housing crisis while ignoring the boom of the 90s that this credit helped create.

Posted by: twweaver7777 | March 29, 2010 11:33 AM | Report abuse

twweaver7777,

I think you bring up a good point. You're entirely correct that higher capital requirements will reduce credit available and raise the price of credit.

We do have to keep in mind that financial crises tend to have very severe costs. The costs in terms of lost output, failure to develop human capital, much higher levels of government debt and associated interest payments and long streches of unemployment and ruined lives over the 2007-2015? period will be very large.

Given that banks and their depositors are for the most part bailed out in financial crises, I think you need to encourage minimal levels of capital requirements to reduce the odds of a bailout. As Ezra said, the biggest problems with the investment banks with 30:1 leverage ratios - commercial banks with 12:1 leverage ratios faired a lot better, and its not as if commercial banks were offering terrible credit terms on their products.

Some economists actually advocate using no leverage (Laurence Kotlikoff today, economists like Irving Fisher back several generations ago). Any short-term costs in credit contraction should be offsettable by the central bank creating enough money to keep nominal GDP on a stable growth path.

http://people.bu.edu/kotlikoff/newweb/LimitedPurposeBanking1-27-09.pdf

At the end of the day, I'd be in favor of either limited purpose banking, or very simple but strict capital requirements (e.g. 7.5% minimum required capital, plus an extra 0.1% for each 0.1% of total U.S. bank credit your bank's credit represented so if your bank had 3.5% of the country's bank credit on its balance sheet, it would be required to have an 11.0% capital ratio). The step up in bank capital requirements should incent banks to avoid TBTF status.

Posted by: justin84 | March 29, 2010 12:30 PM | Report abuse

All valid points, but the Leonhardt excerpt is completely wrong about the definition of leverage ratios.

A leverage ratio of 12 to 1 implies $12 of liabilities for every dollar of net equity (and roughly the same amount of assets as liabilities -- banks borrow to reinvest). It is NOT that there would be $12 of liabilities for every $1 assets. If that were the case, every bank would be massively insolvent.

Posted by: bhawk99 | March 29, 2010 4:49 PM | Report abuse

Please, please, please, stop saying FinReg! Seriously. I love you, but it seriously sucks.

Posted by: bridgietherease | March 29, 2010 5:40 PM | Report abuse

bhawk99,

Good catch.

Posted by: justin84 | March 29, 2010 7:20 PM | Report abuse

Ezra,

Leonhardts explanation, while clear, is incomplete. The 12:1 ratio isn't a happenstance of banking conservatism, but is the currently existing regulations. In 2005, the five banks listed each asked for, and received, permission from the SEC to move past the 12:1 ratio. Lehman and Bear Stearns ended upwards of 40:1 and it is speculated that they may have gone as high as 60:1 (with disastrous results) but we may not know for sure because they may have engaged in some creative accounting.

It's important to note that the 12:1 ratio is a target: banks sometimes exceed this because of the fluid nature of their business, but AT THE VERY LEAST, it is the reddest of red flags and any bank that finds itself in territory beyond the 12:1 ratio ought to re-assess their risk management strategies. To deliberately go beyond the 12:1 ratio suggests an optimism bordering on insanity.

So, while we're on the subject of nomenclature (finreg?? really?) we ought to change the phrase 'too big to fail' to the phrase 'to leveraged to fail' (since leverage represents tentacles into other firms/institutions and is therefore a measure of entanglement...)

Posted by: swedock | March 30, 2010 8:07 AM | Report abuse

Err... My bad. It was 2004 in which the SEC relaxed rules for leverage and capital requirements... Cites below...

http://www.nytimes.com/2008/10/03/business/03sec.html

http://www.nysun.com/business/ex-sec-official-blames-agency-for-blow-up/86130/

http://www.realclearmarkets.com/articles/2009/02/the_sec_killed_wall_street_on.html

Posted by: swedock | March 30, 2010 8:20 AM | Report abuse

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