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Can't regulate what you can't see

Simon Johnson and James Kwak say that limiting leverage would be all well and good, but that it's too easy for banks to hide how leveraged they really are. Stephen Waldman agrees. Kevin Drum doesn't.

I'd side with Drum, though I'm not terribly confident. Two reasons: First, I've done a fair bit of reporting on this issue (including trying to figure out how enforceable domestic leverage requirements would be), and the experts I've spoken to -- a distinguished, if not comprehensive, list -- all agreed that domestic leverage requirements could be imposed on the banks and would have an effect. The downside, they thought, wasn't that the requirements wouldn't work, but that they'd work too well: If we had caps and other countries didn't, our banks would be less competitive. This is a major reason that banks and bank-friendly legislators want to let regulators set leverage requirements.

Second: The banks really, really don't want leverage requirements. Resolution authority? Sure. Funeral plans? They'll draw them up. But they don't want their leverage capped. That may be because they don't want to go to the trouble of evading the caps. But it seems likelier that they're at least as worried that the caps will be effective as Johnson and Kwak and Waldman are that they'll be sidestepped. Now, it's possible that nothing short of breaking up the banks and limiting their activities will work, but since it's hard to see how that will pass, capital requirements seem like our best bet.

By Ezra Klein  |  April 7, 2010; 1:03 PM ET
Categories:  Financial Regulation  
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They may not want leverage caps, but they've illustrated that driving without seatbelts just doesn't work. And much more useful and effective than funeral plans.

"We just want to be able to loan out all the money we have perpetually, so the minute two people ask for their cash at the same time, we go belly up and crash the economy!"

Yes, of course you do.

Posted by: Kevin_Willis | April 7, 2010 1:28 PM | Report abuse

If the potential disparity between foreign and domestic banks is the problem, then try imposing the rules on the foreign banks also. Have the rule say that if you want to do business in the US, you have to meet the leverage requirements. There might be a comity issue here, but too often comity destroys any meaningful reform which has to happen on an international scale.

Posted by: zathraszathras | April 7, 2010 1:47 PM | Report abuse

Ezra, I have to say I think you're missing it. My reading of Johnson & Kwak isn't that they doubt that leverage requirements *could* be enforced (in the post you linked to this was only the third of three identified 'problems', as was supposed to be derivative of the other two. Problem 1: who should get big capital reqs. and how high should they be? They want this to be a simple, public answer that's explicitly stated by legislation, because of .... Problem 2: call it "suboptimal" behavior on the part of regulators: they get captured, they don't see the crisis coming, they're forced to compete for banks by advertising leniency. This quickly leads to forbearance, deference & advocacy by regulators on behalf of banks. For all these reasons, leaving it to regulators to figure out who's risky, what the probability and consequences of their failure would be is not a good primary line of defense. Nobody's that smart, if anyone were they'd likely choose to play for the other team, and if they did find themselves on the side of the regulators their incentives would be all wrong. Problem 3: that banks will game the system, seems obvious but of lesser importance to me. J & K's point is that leverage reqs might hurt the banks, but that's not enough to show they banks won't still be able to bankrupt the country by once again doubling our debt to GDP ratio.

Posted by: viveapple | April 7, 2010 1:53 PM | Report abuse

Also, the economic argument is worth having, but I don't think the idea that leverage caps "would make our banks less competitive" is exactly a knockout argument against them. Is the idea supposed to be that having our comparative advantage lie in exciting financial engineering is better than not having one at all?

Posted by: viveapple | April 7, 2010 2:11 PM | Report abuse

Do Canadian banks compete with ours internationally? Were they losing the competition before Bear Stearns went under because our banks, particularly investment banks, were more loosely regulated? How have they done since the crisis?

Posted by: bharshaw | April 7, 2010 2:44 PM | Report abuse

What really does Kevin Drum know about finance? Even if he's right, saying "I side with him" sounds ridiculous. First, you don't know. Second, he doesn't know. Third, we don't know if the experts he consulted know.

That's why this Fin Reg thing is such a shot in the dark. Expect Congress to pass something that essentially changes nothing and call it a day.

Posted by: bmull | April 7, 2010 6:50 PM | Report abuse

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