Why Not a Hard Leverage Cap

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The House version of financial regulatory reform sets a hard leverage cap of 15:1 while giving regulators discretionary authority to allow even less regulation than that. Neither Chris Dodd nor the Obama administration supports this measure. Mike Konczal considers Tim Geithner’s reasoning and finds it wanting.

I’m trying to keep as much of an open mind as possible about these financial regulation issues. Pundits have a lot of incentive to pivot from our firm convictions about health care policy to suddenly developing firm convictions about financial regulation. But the fact of the matter is that I simply have far less background on the financial regulation issue than I do on health care (and I’m pretty sure I’m not alone) so I’m going to try to tread cautiously. That said, I can see two decent arguments in favor of full discretion:

1. International Issues: Setting up a hard cap of 15:1 creates a kind of odd incentive for some other country’s regulators to park their leverage cap at, say, 16:1. That’s pretty much as good as 15:1 from the standpoint of prudence but more profitable for banks. Then financial activity starts to leave the US and migrate to Jurisdiction X. Now we’ve lost money and nothing’s really been achieved in terms of systemic stability. If regulators have flexibility, then the Treasury Secretary can call up the Finance Minister of Jurisdiction X and say “we can all see where this is going, I go to 17, you go to 18, I go to 19, and next thing you know we’ve evened out at 40 and the whole world goes bust—let’s just have a level playing field at 15.”

2. Cyclical Issues: If you’re in the midst of a sharp economic contraction facing a credit crunch, you arguably really do want to permit any firm that’s daring enough to lever-up a whole bunch. Recoveries are led, almost by definition, by the irrationally incautious so near the bottom of the business cycle there’s a case for letting the incautious really go to town.

The case against discretion is that you’re just going to see regulatory capture and business running amok.