Simon Johnson has an excellent post on Baseline Scenario regarding the debate about bank capital. This debate is often in the background because there is a prevailing assumption that super high leverage is and should be the norm for financial services. Why?
The debate in the last week became higher profile as a result of a piece on Jamie Dimon in the New York Times Magazine. Check out that cover. In the piece, Dimon is framed as a competent and reasonable man. He sounds reasonable. What he says is reasonable from within the paradigm he lives.
Dimon does not dispute that mortgage lenders and investment banks deserve a lot of the blame. But regulatory lapses and excess leverage throughout the system, he says, contributed as well. What gets him riled is his sense that Washington is captive to a binary, us-against-them environment in which bankers are cast as villains. Perhaps naïvely, he was disappointed that political concerns played a large role in shaping the legislation. (An example is that Dodd-Frank limited bank investment in hedge funds, even though the latter were peripheral to the crisis.) In contrast, Dimon admires the approach of the members of the Basel Committee, the international regulators who are imposing heightened capital requirements, because they are asking the questions that, in theory, bankers ask of themselves: how much capital do banks need to withstand the inevitable downturn, and what is an acceptable level of risk?
Basel is a very minor tweak in capital requirements. Simon Johnson’s take?
There is one problem, however. Basel may have asked the right question, but it did not come up with the right answers, mainly because it allows banks to remain dangerously leveraged, setting equity requirements way too low.
My beef is with the way the argument is conducted. This has become typical in our media bite culture. Make a quick assertion, repeat it endlessly, and people buy it. Here is the argument bankers are making about capital, in Simon’s words:
Bankers tell us that they must be allowed to maintain high leverage because this is part of the business of banking. They assert that economies will suffer if they are made to fund more of their investments with equity, there will be credit crunches, terrible things will happen. We clearly must examine these statements carefully before agreeing.
To summarize Simon’s point, he is saying that high leverage is a result of a combination of government policy that promotes leverage in a variety of ways, such as regulation, the tax code, implicit guarantees for TBTF institutions, and private interests that benefit from leverage because of the large profits and compensation it can bring to bankers and shareholders. I agree with Simon on this. The leverage that exists in the system is natural because of the assumptions that all of us are operating under. If you throw out the assumption that high leverage is the norm, is necessary for the economy, and that reducing leverage will cause a crisis, than you are no longer bound by the logical end point of those assumptions, which is to not rock the boat. You can ask, “why”? And you can realize that there are alternatives.
The existing banking system will persuasively argue its book every time. That does not mean anyone else has to buy it. If there is to be a banking model that is less leveraged and produces less fragility for the system, society has to choose it.