Explaining financial regulation: Leverage and capital requirements
If you watched the Sunday shows this weekend, they were thick with politicians and administration officials arguing over financial regulation. But the gladiators were getting ahead of the audience, and they knew it. On Meet the Press, Treasury Secretary Timothy Geithner began explaining the need to "move derivatives out of the dark" only to be cut off by host David Gregory. "We have to stop and tell people what a derivative is," Gregory said.
Indeed we do. This week, I'll be trying to explain the basic elements of financial reform. And we're going to start with the most important bit: Leverage and capital requirements.
What you need to know, first, is that the words "leverage" and "capital requirements" are different ways of talking about the same thing. Leverage refers to how much money you've borrowed compared with the capital you have on hand. Let's say you're buying a house, and you put 20 percent down. Your leverage is 5:1. For every dollar you had in capital, you've borrowed four more to complete the sale.
If you're a bank, the upside of leverage is that it gives you a lot of money that you can use, well, to make more money. It's the difference between investing $1 in the stock market and $40.
The downside is that it makes your firm fragile. If your leverage is at 2:1 -- that is to say, you've borrowed one dollar to add to the dollar you already had -- you could lose a full dollar and still be able to pay your creditor back. If you're at 10:1, anything beyond a 10 percent decline in your assets means that if your creditors want repayment, you can't pay them back (as you've lost more than your original dollar). At 20:1, a 5 percent decline will put you underwater. At 40:1, a mere 2.5 percent decline can finish you off. You can see the ratios in the graph atop this post. The more leverage you have, the less bad luck you can survive.
Leverage also helps firms become too big to fail. A firm with a billion in capital can have $40 billion in liabilities, which means that if it goes down, there are other banks and lenders who need $40 billion in repayments if their balance sheets are going to add up. The banks that survived the crisis best, like J.P. Morgan, had the lowest levels of leverage.
That's led many observers to focus on capital requirements -- regulations limiting the amount of leverage firms can take on -- as the most important regulation going forward. "The reason I raise the capital issue so often," Alan Greenspan said in testimony to the Financial Crisis Inquiry Commission, "is that, in a sense, it solves every problem." Timothy Geithner was no less complimentary. “The top three things to get done are capital, capital and capital,” he told David Leonhardt.
The question, of course, is how you get "capital, capital, and capital" done. The most basic approach is to look at what's called "gross leverage ratios." That's what we've been talking about here: The amount you've borrowed for every dollar you've got in capital. But the worry is that companies can skirt those rules by purchasing riskier assets with the leverage they do have. That is to say, they'll respond to low capital requirements by buying riskier stuff in order to keep their profits high. It would be a little like someone responding to gastric bypass surgery by only eating butter and chocolate truffles.
The way to handle this, in theory, is "risk-adjusted capital limits." In this telling, regulators go in, look at the stuff you're buying, and then set capital requirements that are responsive to the realities of your balance sheet. In other words, if you've decided to load up on truffles and butter, you won't get to have as much of them.
These ideas are not either/or. You could have gross capital requirements plus the option for regulators to impose harsher capital requirements in response to firm behavior. "There is no perfect solution," says David Moss, the John G. McLean Professor at Harvard Business School. “But lower leverage should definitely help. It’s like washing your hands. It may not totally prevent a cold. But it apparently reduces the odds quite a bit."
The financial regulation bill that passed the House of Representatives includes an amendment that Moss helped craft and that Rep. Jackie Speier sponsored that forces the financial sector to do a lot of hand-washing: It sets a 15:1 gross leverage limit and then gives regulators the ability to clamp down further if they so chose.
That's not the administration's preferred route. They'd like to see the capital requirements left entirely up to regulators. There's also an international conference of regulators called Basel III that's expected to set some new capital requirement rules.
That said, when something is left to the regulators to decide, it is also there for the regulators to un-decide. So many believe capital requirements should be written into law at a moment when the dangers of leverage are fresh in our minds rather than left to regulators who might loosen them when memories of the meltdown fade.
April 19, 2010; 11:33 AM ET
Categories: Explaining financial regulation , Financial Regulation
Save & Share: Previous: Names you should know: Neil Wolin, Michael Barr, Diana Farrell
Next: Lunch Break
Posted by: tmorgan2 | April 19, 2010 12:44 PM | Report abuse
Posted by: dgs290 | April 19, 2010 12:56 PM | Report abuse
Posted by: justin84 | April 19, 2010 1:26 PM | Report abuse
Posted by: JamesCody | April 19, 2010 1:48 PM | Report abuse
Posted by: rmgregory | April 19, 2010 2:12 PM | Report abuse
Posted by: donkensler | April 19, 2010 3:08 PM | Report abuse
Posted by: lagnafrah | April 19, 2010 3:38 PM | Report abuse
Posted by: justin84 | April 19, 2010 4:14 PM | Report abuse
Posted by: moonglowsun | April 19, 2010 6:51 PM | Report abuse
Posted by: JamesCody | April 19, 2010 7:17 PM | Report abuse
Posted by: ztcb41 | April 19, 2010 7:34 PM | Report abuse
Posted by: JPRS | April 19, 2010 8:51 PM | Report abuse
Posted by: paul314 | April 19, 2010 8:55 PM | Report abuse
Posted by: hitaxpayer | April 19, 2010 9:21 PM | Report abuse
Posted by: justin84 | April 19, 2010 10:24 PM | Report abuse
Posted by: onehanded | April 19, 2010 10:41 PM | Report abuse
Posted by: wpcharowhas | April 19, 2010 10:59 PM | Report abuse
Posted by: JPRS | April 20, 2010 12:15 AM | Report abuse
Posted by: chase-truth | April 20, 2010 8:13 AM | Report abuse
Posted by: RonKH | April 21, 2010 2:05 AM | Report abuse
Posted by: RonKH | April 21, 2010 2:05 AM | Report abuse
Posted by: patPatterson1 | April 21, 2010 2:16 AM | Report abuse
Posted by: OfConservativeMind | April 21, 2010 11:56 AM | Report abuse
Posted by: patPatterson1 | April 21, 2010 12:29 PM | Report abuse
The comments to this entry are closed.