In a recent op-ed, Sheila Bair recited a litany of age-old canards about leverage requirements and leverage reform that are as untrue as they are outdated.  Below, we address the key misrepresentations that have been made about leverage requirements, risk-blind capital requirements that compare a bank’s equity capital to a measure of its total assets without regard to their riskiness, and discuss why the economy needs leverage reform in the near term.

The Facts:

  1. Risk-based capital requirements did not cause the financial crisis.  The op-ed argues that an overreliance on risk-based capital requirements caused the 2008 financial crisis.  According to this worldview, the financial crisis could have been largely averted if only regulators had relied on leverage capital rather than risk-based requirements.  This claim does not comport with the basic fact that U.S. banks were subject to a leverage ratio for years before and during the financial crisis.  Additionally, and importantly, economic scholars such as Former Federal Reserve Chairman Ben Bernanke who have painstakingly studied the financial crisis have shown that the proximate cause was a run in the non-bank sector that was tied to the non-bank funding of mortgages.  Importantly, Bear Stearns, Lehman Brothers, Countrywide Mortgage, Fannie Mae, Freddie Mac and the money market mutual fund industry – all non-banks – failed and took a heavy toll on the economy long before a single bank failure occurred.
  2. Risk-based capital requirements are not “gamed” by banks.  The op-ed asserts that a key motivation for simplistic, risk-blind capital requirements is that they are “simple and transparent” and therefore can’t be “gamed” by the banks.  This view of risk-based capital requirements has been outmoded by the very significant capital reforms that were enacted post-2008.  Specifically, under Basel III, large banks are subject to standardized risk-based capital requirements that assign regulator-specified risk weights to various asset types that are defined and classified by regulators.  Further, the stress tests to which all large banks are subject are unilaterally determined by regulators without any bank input.  Current risk-based requirements are determined by regulators and are not “gamed” by the banks.
  3. The leverage ratio is not “neutral” to capital allocation.  The op-ed asserts that leverage ratios are “neutral” to capital allocation.  This statement is incorrect.  Leverage requirements mandate that every asset be funded with the same amount of equity capital.  Low-risk assets, such as U.S. Treasuries and bank reserves, provide correspondingly low levels of financial renumeration.  But the total cost of funding any bank asset is determined by the amount of equity that is required to fund the asset.  Requiring low-risk and low-yielding assets to be funded with the same amount of equity capital as higher yielding assets disincentivizes banks from putting lower yielding assets on their balance sheet.  As long as leverage ratios assign the same marginal capital cost to assets with both low and high levels of risk, lower-risk assets will face a steep disadvantage.      
  4. A binding leverage ratio is not evidence that risk-based capital requirements are too low.  From a fundamental risk perspective, leverage capital requirements are completely arbitrary.  Imagine a different, completely arbitrary, requirement that determines a bank’s capital requirement in terms of the number of letters in its name stated as a percentage.  Under this rule, ACME Bank would have a capital requirement of eight percent.  If we found that the risk-based capital requirements for ACME Bank were lower than eight percent, would we conclude that the risk-based requirements were too low?  Surely not.  A capital requirement with no basis in risk cannot, by design, be used to measure the adequacy of a risk-based system.  This statement is as true for leverage-based capital requirements as it is for “name-based” capital requirements.  Further, large U.S. banks have tripled their capital levels since the financial crisis and have also increased their capital by roughly 20 percent since 2020.  Any assertion that a binding leverage ratio points to insufficient risk-based capital requirements is both conceptually flawed and oblivious to the basic facts on large bank capital levels.
  5. Lowering the cost of issuing Treasuries does not “re-direct capital away from the private sector and into public coffers.”  This statement in the op-ed ignores the fact that the borrowing cost for U.S. Treasuries sets the “base rate” that directly impacts the cost of borrowing for every other type of credit.  The borrowing cost for auto loans, student loans, home mortgages, business loans and every other form of credit is directly tied to the “risk-free rate” that is required on U.S. Treasuries.  Accordingly, improving the market for U.S. Treasuries is a two-fer: it reduces the cost of the U.S. taxpayers’ debt burden and it helps reduce the cost of borrowing for every other form of credit used by businesses and households.  

Leverage-based capital requirements are fundamentally flawed in a way that disadvantages low-risk assets, distorts capital allocation, and impedes the efficient flow of credit in the U.S. economy.  In addition, the U.S. economy and financial system have significantly evolved since the 2008 financial crisis, rendering leverage capital requirements increasingly outdated.  Outmoded and arbitrary leverage capital regulations have been backfiring on the U.S. economy for years and are in serious need of reform.  Recent commitments by regulators and other officials to reform leverage requirements is a welcome development that we should all embrace to improve our banking system and the economy.