Easing leverage limits on banks might backfire | USAEMALL.com

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The writer is the former chair of the FDIC and author of ‘Money Tales’, financial education books for children

US Treasury Secretary Scott Bessent has said he wants to deregulate the financial system responsibly. He has pointed to relief for community banks and other valid areas for reform.

Unfortunately, he has also floated a big bank priority: loosening limits on “leverage” — the ratio of bank’s debt to equity — and eliminating those restraints entirely for investments in short-term Treasuries. This would repeat regulatory errors that led to past financial crises, while giving banks powerful incentives to buy government debt at the expense of private sector lending.

Regulators have long sought to limit banks’ reckless use of leverage by requiring they maintain minimum levels of their own equity capital. They apply “risk-based” standards which vary capital minimums based on the perceived riskiness of different categories of assets, and a “leverage ratio” which is an overarching constraint on banks’ use of borrowed money.

Under risk-based standards, banks can boost their returns on equity by allocating capital to “safe” assets where regulators require lower levels of capital. Their ability to manipulate risk-based requirements, however, is constrained by the leverage ratio, which is neutral as to capital allocation.

While bank capital rules are supposed to keep the financial system stable, the risk-based rules have, in the past, been a central cause of financial crises. This is because they encouraged banks to pile into activities that regulators (and the bank lobby) viewed as “low risk”, but in fact were anything but.

The 2008 financial crisis was driven by capital rules that treated mortgages, including securities and derivatives tied to mortgages, as low risk. This fuelled a housing bubble in the US that when it collapsed, brought the world economy to its knees. A year later, Europe’s financial system teetered as banks incurred losses on investments in the “safe” debt of struggling EU countries. Again, these investments had been incentivised by risk-based capital rules that treated sovereign debt as having zero risk.

In the US, we were fortunate to have a leverage ratio for commercial banks before the 2008 crisis that contained some of the damage. But leverage ratios did not apply to European banks, where risk-based capital rules enabled extreme levels of leverage. Given the spectacular failure of risk-based capital rules, regulators across the globe adopted leverage ratios as a backstop to risk-based requirements. And in the US, leverage ratios were expanded and enhanced for the largest banks.

Big banks have long complained that the leverage ratio is supposed to be a backstop, but too often requires more equity capital than the risk-based rules, thus becoming a binding constraint. But the point of the leverage ratio is to create a minimum capital base as a check against imperfect risk-based standards. If it is too often binding, that suggests the risk-based ratios should be strengthened, not that the leverage ratio should be weakened. 

Big banks also argue that the leverage ratio requires unnecessary capital against money held in Federal Reserve accounts and investments in Treasury securities which are treated as having zero risk under the risk-based rules. This mischaracterises the leverage ratio, an overarching constraint on a banks’ use of leverage to finance all of its loans and investments. Its 5 per cent minimum equity requirement may seem high for Treasury debt, but far too low, say, for property development loans. In any event, US debt is not “risk free” as recent market conditions have made painfully obvious.

Bessent has stated that eliminating all capital requirements on short-term Treasuries could bring their rates down by 0.3 to 0.7 percentage points. True, it would provide a powerful incentive for banks to buy more government debt, thus lowering yields. But it would also likely redirect capital away from the private sector into public coffers. Far from increasing credit availability to support economic growth, it could serve as a brake as more bank assets would move into T-bills or sit idly in Fed accounts where banks could make easy profits. 

Any measure to reduce interest costs on the US national debt sounds tempting, but it is better to trim deficits than weaken bank capital rules. The Fed, an independent agency that must write the new capital rules, is reportedly reluctant to exempt Treasury debt. If it does, it should at least cap the amount that can be exempted. It should also carefully consider the precedent of using bank capital rules to address fiscal challenges. That might even be more dangerous than the exemption itself.