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The Danger of Allowing Banks to Artificially Boost Capital Ratios

Thought Leader: Sheila Bair
August 18, 2020
Source: Link

By Sheila Bair (original source Yahoo Finance) 

“’Never let a good crisis go to waste,’ Rahm Emmanuel famously said in 2009.  As President Obama’s Chief of Staff, he was speaking of the opportunity to achieve meaningful financial reforms in the aftermath of the Great Financial Crisis. 

Ironically, big bank lobbyists are now using the Covid-19 crisis to undo those very reforms, cynically claiming deregulation will help banks support the real economy. Their primary target is the leverage ratio, a key measure of financial stability which big banks have long despised because it places hard and fast constraints on their ability to use unstable leverage to generate high returns. Weakening the leverage ratio will reduce the capital resiliency of the banking system, while giving banks incentives to actually reduce lending to artificially boost their capital ratios. 

It is generally recognized that a main cause of the 2008-2009 financial crisis was excessive reliance on debt, or “leverage,” by large financial institutions. Central to post-GFC reforms was a strengthening of rules that require banks to fund themselves with a minimum amount of equity capital.  There are two sets of requirements: “risk-based” rules which set minimum capital based on the perceived riskiness of a bank’s assets and “leverage ratios,” which do not allow such adjustments. A key disadvantage of risk based requirements is that they are subjective. They failed spectacularly prior to the GFC, when US and European regulators wrongly assumed mortgages and sovereign debt were low risk. The disadvantage of leverage ratios is that they are not risk-adjusted, requiring the same amount of capital against a US Treasury security (which we hope is safe) as a loan to Boeing. Each has strengths and weaknesses, which is why regulators use both.”

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