Should banks have less leverage?

November 12, 2013

We had a fascinating event last Wednesday, hosted by the Center, about how to make banks safer. A packed house was there to hear Anat Admati, Tom Cooley, and Mervyn King exchange ideas about bank regulation, a once obscure (can I say boring?) topic that became more interesting after the global financial crisis.

The rules of the event preclude quoting individuals, but an astute listener might have detected a provocative line of thought among the competing ideas. Here’s one take, not attributable to any one person.

  • Subsidies. Banks benefit from subsidies to their cost of financing through deposit insurance and an implicit understanding that (large) failing banks will be rescued.
  • Leverage. These subsidies, plus the bias in the tax code toward debt*, lead banks to take on more debt — and more leverage — than they would otherwise.
  • Capital. One way to correct this bias it to require banks to hold larger equity buffers: to have more capital and less leverage.
  • Implementation. The hard part, of course, is deciding how much capital to require. Cue impenetrable discussion here (actually, that’s the simplest version I know, but you’ll get the idea).

More to come on this, for sure, but what do you think? Are banks now adequately capitalized or overleveraged? How can we tell?

*For US corporate taxes, interest payments on debt are a deductible expense, but dividends paid on equity are not. It’s arguably one of the least attractive features of our tax code.

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