Keep It Simple(r)

In the last couple of weeks, banking regulators in the U.S. and Europe have tightened rules concerning a financial measure known as a leverage ratio. The rules should make the banking system stronger, but that is only part of their appeal. One of their virtues is that they reverse half a century of increasingly complicated regulation by asserting a new idea: keep it simple.

A bit of background. Starting in 1974, regulators from a dozen countries came together in Basel, Switzerland, to find ways to make the world financial system safer. One of the subjects they discussed was capital, which is shareholders’ funds that are available to repay depositors and trading partners if the bank goes bust. Capital doesn’t produce a return for shareholders, so banks have an incentive not to hold a lot of it. By the 1970s, many banks, especially in Japan, had very little, and regulators responded by requiring banks to hold more, measured as a percentage of their assets.

Predictably, banks objected to this idea. One objection was that setting a higher capital-to-asset ratio would create a perverse incentive for banks to own riskier assets, such as loans to dodgy borrowers, which yield much higher interest rates than government bonds. If regulators were going to treat all types of assets the same way, the banks argued, banks would inevitably favor junkier borrowers to earn more money with a given amount of capital, and this would make the financial system less stable, not more.

The regulators came up with a compromise: the amount of capital required would depend on the types of assets a bank owned. At one end of the spectrum, loans to most businesses were deemed to be high-risk and had to be backed by a lot of capital. At the other extreme, loans to rich-country governments were deemed low-risk and required no capital at all. Over time, this seemingly sensible idea was taken to remarkable extremes. “Risk-based” standards were put in place, and were applied to banks’ trading businesses as well as their lending. This got so complicated that banks were allowed to figure out for themselves how much capital they should have, and clueless regulators couldn’t do much more than say “amen.” For more about this unfortunate development, you can see an article I wrote a couple of years ago.

Then, when the crisis came in 2008, regulators and bank investors discovered that banks had much less capital on hand than they were thought to have. The problem became acute in 2010, when Greece was unable to service its bonds. French and German banks had gorged themselves on Greek bonds precisely because they did not need to hold capital against which had been deemed “low risk” government debt. Had Greece not received an international bailout in May 2010, several big European banks could have gone bust.

The new rules on leverage ratios are meant to stop banks from gaming the system. They require most banks to add up their loans, their exposures to credit derivatives, and certain other commitments, and then to hold a certain percentage of that amount in capital, without adjusting for risk. The biggest banks will have to hold even more. This means that banks can’t get away with minimal capital by claiming they have low-risk businesses. Owning dubious Greek debt in order to avoid capital requirements will no longer make sense.

You’ll hear words like “crude” and “imprecise” thrown around by critics of the new leverage ratios. And there’s no question: they are crude. But what matters more is that they are relatively simple to enforce and harder for banks to manipulate. Banks businesses will continue to be very complex, but having some simple regulatory limits is worth a lot.

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