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Geithner's attack on leverage requirements

By Mike Konczal
Hello, all. My name is Mike Konczal, and I'm a blogger on financial reform these days at Rortybomb and the Roosevelt Institute's New Deal 2.0 blog. I'll do my best to keep the financial reform material accessible for a general audience while interesting for those with a deeper background. I'll also lay out arguments for what progressives, conservatives and those in favor of stronger financial reform should fight for in terms of what is currently on the table next week.

I should start off by saying this is not an April Fool's Day joke.

Paul Krugman wrote about the current financial reform bills, and uses a great metaphor for regulatory regimes. Greek armies were specialized and fought better when they had great leaders, while Roman armies were more generic but worked better under poor leadership. “And in the end, since mediocre leaders are the norm, the Roman way prevailed." Reformers are worried that the financial reform bill is too Greek and not Roman enough, and requires the regulators who will carry out reform in the future to be too smart.

Krugman has also written that a 15:1 leverage cap is the most Roman part of a bill as it idiot-proofs the financial regulation. Part of the reason that so much damage occurred in the financial crisis is that the SEC, for whatever regulatory capture reasons, let the major shadow banks lever up in the 30-to-1 range after a review. In retrospect, that was a dumb thing to do; millions of people are out of a job because of it. So let's remove the bad incentives for the regulators and create a floor under which the damage can't spread.

Kevin Drum is also a huge fan of these leverage requirements, writing "Congress should put in place an absolute ceiling that can't be easily wisked away by the SEC or the Fed when times are good and everyone thinks they're going to last forever."

So who is fighting against this? I always like to read both sides of an argument, even when I strongly agree with one side as I do here, to see what the best counter-argument is. So I started asking around, and instead of a Republican, everyone I asked says that I really need
to check out the writings of Treasury Secretary Timothy Geithner, who is really arguing up a storm on keeping leverage requirements out of the bill.

Geithner is working overtime to keep leverage requirements out of the bill? That's weird, no?

Well, here is a letter from Geithner (PDF) to Rep. Keith Ellison, dated Jan. 11, 2010, in response to a letter the congressman wrote asking for some advice on how to put a leverage requirement in the financial reform bill. Let's check out what Geithner wrote:

Although the Administration strongly supports imposing a simple, non-risk-based leverage constraint on banks, bank holding companies, and other major financial firms, we do not believe that codifying a specific numerical leverage requirement in statute would be appropriate.

Devising and calibrating regulatory capital requirements is a complex endeavor. ... Placing fixed, numerical capital requirements in statute will produce an ossified safety and soundness framework that is unable to evolve to keep pace with change and to prevent regulatory arbitrage. ...

The statutory leverage constraint and detailed statutory risk-based capital requirements for Fannie Mae and Freddie Mac proved to be inadequate to the task of ensuring the safety and soundness of the firms. ...

Finally, preserving the flexibility of the Federal Reserve and the other U.S. banking agencies to design and calibrate a leverage constraint for U.S. financial firms is essential to enable the agencies to successfully negotiate a robust international leverage ratio that works in all the major jurisdictions and does not leave U.S. firms at a competitive disadvantage to their foreign peers.

Thank you again for your commitment to these critical issues, and I look forward to working with you as we enact comprehensive regulatory reform legislation.

Timothy Geithner

cc: The Honorable Ben S. Bemanke


A few things:

(1) Like "providing liquidity," whenever I hear "competitive disadvantage" as the main reason to not do a sensible financial regulatory related thing I think that there's some real shenanigans going on.

By the way, for those who think the statute will bind large systemically firms to less risk than commercial banks or other smaller firms, keeping rules out lest we disrupt our "competitive disadvantage" sure seems to go against that.

(2) A floor is not a ceiling. I understand that it is possible to write this bill as if a floor becomes a de facto ceiling, where following this simple rule is all that we do, but the statute gives regulators a huge amounts of discretion to establish prudential standards that this doesn't seem like a real worry. And if it is, shouldn't they be advising how to best go about it?

(3) "If you put this in the bill you will be responsible for another Fannie and Freddie" is so ridiculous I don't even know where to begin. But wow, from a legislator's point of view what a scary thing for a Treasury secretary to write to you. And that's how intense the pressure is to not put any hard rules in the bill. I guess the regulators don't want anyone spoiling the party.

Mike Konczal is a fellow with the Roosevelt Institute and the author of the Rortybomb blog.

By Washington Post editor  |  April 1, 2010; 9:16 AM ET
Categories:  Economic Policy , Financial Regulation  
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Just one more reason to fire this tax cheat!

Posted by: obrier2 | April 1, 2010 9:30 AM | Report abuse

' "If you put this in the bill you will be responsible for another Fannie and Freddie" is so ridiculous I don't even know where to begin.'

I don't think this is fair. It's fair that this would be a ridiculous thing to say, but I don't think it's what he meant. I read it as "we put a hard constraint on Fannie and Freddie and they still went bust," not that they went bust because of the constraint.

Posted by: zimbar | April 1, 2010 9:47 AM | Report abuse

Limitations on leverage are inherently conservative. Any Republicans who fight FinReg based on common sense leverage restrictions are out of their mind. There may be other objectionable things that come out of FinReg, but preventing overly-optimistic companies from leveraging themselves more than enough rope to hang themselves (and hundreds of thousands of every day folks who get caught in the tidal wave of their collapse) just makes sense.

Not ever regulation is government micromanagement. We recognize that murder is bad and one ought to drive on a particular side of the road to avoid traffic accidents. Well, leveraging yourself to the hilt is crazy. The higher the leverage, the fewer people who need to cash in to crash the bank. It gets to the point where a small economic downturn--where investors need to access their money--ends up with a run on the bank and the bank going out of business and people losing their jobs and (sometimes) savings, or the tax payer footing the bill . . .

It shouldn't even be controversial that allowing companies to leverage themselves 30 or 40 to 1 is crazy--that it will end up hurting everybody, not the least of which would be their creditors (or investors, or customers), all of whom have a stake that we recognize as important. Otherwise, we would not have contract law.

And, yes, Geithner was an interesting choice. Very much a Friend of Wallstreet. At the expense of the taxpayer.

Posted by: Kevin_Willis | April 1, 2010 9:59 AM | Report abuse

From everything that you, Simon Johnson, Yves Smith and others write, there is much wrong with the current Senate bill and the House bill isn't any better. I agree. But it appears as though Senate Republicans are going to fight a delaying game, for political purposes, and hope to dilute reform even further. Or so they're telling the ABA.

In addition, Geithner is not helping to clean up the financial system with the weak oversight and rules he advocates.

I don't think Washington realizes how much anger is out in the heartland over the financial system. The people want strong rules to defend them against another financial meltdown and Great Recession.

I hope voters listen to you and will write, email, or call their representatives to demand what you and your colleagues advocate.

Posted by: valkayec | April 1, 2010 10:00 AM | Report abuse

@zimbar: 'I read it as "we put a hard constraint on Fannie and Freddie and they still went bust,"'

That would still be kind of ridiculous. Fannie and Freddie were were increasing less restrained (and, frankly, less restrained now than ever) and agitated for fewer constraints in the mortgage lending industry in general, and any time people tried to provide some oversight, or some "reigning in" to Fanny Mae or Freddie Mac, the usual suspects (Barney Frank, Chris Dodd, and other Democrats) went to the mat to prevent any limitations being put on Fannie and Freddie, saying they were totally awesome, nothing wrong, nothing to see here, shut up and go away.

Fannie and Freddie did not have hard constraints put on them--and as the crash approached, what constraints they did have had been considerably slackened.

Posted by: Kevin_Willis | April 1, 2010 10:04 AM | Report abuse

“You can't legislate intelligence and common sense into people” ~Will Rogers

That's one of the lessons collectivists never seem to learn. I think it's related to that old saw about what one does when all one has is a hammer. Government is the hammer all the pinheads run around with whacking things.

Posted by: msoja | April 1, 2010 10:23 AM | Report abuse

I am pretty disposed to agree with you on this, but your third point mischaractarizes what Geithner is actually saying, as Zimbar says above. I would like to see more on Kevin Willis' point above, as that seems more relevant to Geithner's concerns. What is the history of leverage constraints on Fannie and Freddie?

Sure I think Geithner is too banker-friendly, but I also sense that Geithner-bashing has become a popular sport, so mistakes like yours raise caution signs for me. Whether Geithner is the right man for Finance Reform is a good question, but I think people should admit that Geithner's handling of the financial crisis with the stress tests has worked out better than almost anyone expected, so that should give him some credibility and at least make people take his arguments at face value.

Posted by: nathanlindquist | April 1, 2010 12:18 PM | Report abuse

Greg Mankiw recently mentioned a great idea for FinReg - contingent debt.

Basically, you require financial institutions to raise a certain amount of contingent debt, which converts into equity when regulators say a bank's capital level has fallen too low. The cost of that debt will rise as the bank's balance sheet gets riskier, leaning against leverage. On top of that, if the bank ends up failing, the initial recapitalization is from private holders of the contingent debt, not the government.

You could have requirements that are as simple as equity must be at least 5% of total assets, and contigent debt must be 5% of total assets. If your equity to asset ratio falls below 5% - even 4.999% - the contingent debt is trigerred and is converted into equity, and you have to go out and raise new contingent debt.

Posted by: justin84 | April 1, 2010 1:30 PM | Report abuse

Mike-- Ezra never questions the administration so directly. Bad for the career. Try phrases like, "Geithner certainly knows a lot more about this than I do," or "I understand where Geithner is coming from."

Posted by: bmull | April 1, 2010 6:42 PM | Report abuse

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