Over at Simon Johnson's Baseline Scenario blog, Harvard Business School professor David Moss writes a compelling post on the need for financial reform to include leverage requirements, which would require banks to have more capital to back up their borrowing. Anyone who thinks excess leverage wasn't a major cause of the financial crisis needs to study it a little harder. If banks hadn't borrowed so heavily, they would have been better able to absorb the losses associated with the mortgage market, and there may never have been a credit crisis. My favorite part of Moss's piece was his final paragraph, where he reminds readers that limiting leverage is not a new or un-American concept:
For those who worry that limiting leverage is somehow inconsistent with American tradition, it is worth remembering that the nation's founders strictly limited bank leverage in their own time, frequently at less than 4-to-1. Although bank runs remained a problem in early America because of the absence of deposit insurance, the dangers of high leverage were already well appreciated. Let's not lose sight of that wisdom now.
Indeed, there's nothing un-American about being prudent. And 30-to-1 leverage (what some big banks weighed in at in late 2007, according to Moss) is anything but prudent. That means if a bank's assets incur more than a 3.23% loss, then they will become insolvent. Yes, it may have fairly diverse assets, but if the economy gets screwed up enough, such a loss rate is possible -- as we learned in 2008.
So what is the right level? That's not an easy question to answer, but I don't really see much harm in erring on the side of caution. Banks will still be able to make plenty of money -- they just won't be able to borrow excessively to do so. The House's financial regulatory proposal would limit leverage to 15-to-1. The Senate's original version, 10-to-1. What we'll finally get, however, remains unclear.
Of course, excess leverage isn't just a problem for banks: it's also a problem for businesses and consumers. The U.S. was overleveraged in virtually every facet of economics. Too much borrowing and not enough assets is also part of the reason we have so many foreclosures: wacky mortgage products encouraged Americans to have little, no or even negative equity in their homes. If a bank had required a 10% down payment for all homes, then at least that would ensure that the borrower couldn't be more than 9-to-1 leveraged on that loan in isolation.
If we learn anything from the financial crisis, it should be that borrowing can be a dangerous behavior. And that lesson should be most heeded by anyone extending credit. Lenders and counterparties should all take note. Even in the absence of stricter leverage requirements for banks, counterparties should begin worrying about how much leverage the institutions they do business with have. After all, if their borrowing is excessive, there's a chance they won't be able to live up to all their obligations. And creditors to both businesses and consumers should ensure that an economic shock won't result in defaults as well. More prudent lending and borrowing won't restrain the innovative American spirit: it will ensure its survival.