Leverage

LEVERAGE....Contrary to their reputations, bankers have a well-known tendency toward imprudence. After a few years of good times, they usually overreact and start making too many chancy loans. When the market corrects, they overreact in the other direction and turn the loan spigot down to a trickle. This is completely normal.

The same thing is happening now, except worse: credit markets haven't just cooled off, they've almost completely frozen. Partly this is because most modern financial institutions have a big chunk of their assets invested in complex instruments that were originally valued by complex computer-driven models, and when those models failed no one knew how to revalue the affected securities. Trading in them stopped, and when that happened access to credit dried up as well. After all, no one wants to extend credit to institutions holding a bunch of illiquid assets of questionable value.

But that's not all there is to it. Tyler Cowen:
This gridlock is especially harmful because leverage is so high, and financial institutions are so interconnected through swaps and loans. Institutions that rely so heavily on debt are precarious and need up-to-date information about valuations. When they don't have it, markets freeze up. This is what has taken policymakers by surprise and turned a real estate crash into a much bigger financial problem.
In an ordinary commercial bank, leverage is regulated by the capital requirements of the Fed. However, outside the commercial banking system — i.e., most of the global financial industry these days — leverage is barely regulated at all. Capital requirements don't apply, and astronomical bets are made on minuscule and subtle arbitrage opportunites. Because the bets are so big, failure is big too. Today Tyler expands on his suggestion that insisting on consistent capital requirements everywhere is one of the key reforms that we need to consider going forward:
  1. As long as the Fed and Treasury are providing a safety net, insisting on capital requirements is entirely reasonable and it lowers moral hazard. If you're going to bail out your friend in a poker game, you can ask him not to bet too much beyond his chips.

  2. When the "shadow banking system" does not have capital requirements, normal financial activities, as regulated by the Fed, are inefficiently taxed and too much of an economy's leverage ends up in the unregulated shadow banking sector.

  3. If you are anti-regulation on this issue, make the capital requirement relatively low but still impose it symmetrically across financial sectors.

  4. Ideally capital requirements should be adjusted for risk. That probably implies higher capital requirements for shadow banking activity, not lower requirements.

  5. Regulatory issues aside, market participants are less sure of themselves in the shadow banking sector. Derivatives are non-transparent, for a start. That's another reason not to push too much financial activity into the shadow banking sector.

  6. A final solution to excess risk-taking and leverage has to come from shareholders; regulation can only do so much and of course capital requirements are only a small part of regulation. But in the meantime I think the case for more symmetric capital requirements is a strong one, recognizing all the usual comments about horses and barn doors, etc.
This is a no-brainer, I think, sort of a litmus test for hackdom (i.e., if you aren't willing to accept even an obvious reform like this, you're just a hack). After the LTCM debacle of 1998, the great and good, including Robert Rubin and Alan Greenspan,solemnly produced a report explaining that "excessive leverage can greatly magnify the negative effects of any event or series of events on the financial system as a whole," and suggesting that we should
"encourage," "promote," and "consider" guidelines that might prod financial institutions into reducing their drunken sailor approach to leverage. As we now know, the financial institutions of the world gravely considered those recommendations and then went about their business.

Now, among other things, I'd say that Congress also needs to take a close look at the role that rating agencies have played in our current meltdown. They pretty clearly were not operating as honest brokers. But if the Fed is going to act as lender of last resort to everyone, not just Bob's Savings & Loan down the street, then at a minimum everyone needs to be required to restrain their betting to levels that don't threaten the entire financial system if they collapse. This is a pretty moderate proposal, and probably ought to be one of our first steps.

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