Bank regulation: is delevering the answer?

The panel--and already, some of my commenters--are talking about the role of regulators in keeping banks from levering up too aggressively. As I've said elsewhere, repeatedly, this is one of the few proposed reforms that seems like a slam dunk. And pretty much everyone, across the board, agrees.

On the other hand, keeping leverage levels down may not protect the economy from a crisis; it may simply keep the tab down for the taxpayer. To see why, consider the arguement about reserve requirements advanced by my old macro professor, John Huizenga. In theory, a reserve requirement makes the bank safer, right? After all, it means the bank has to have, say, 20% of its outstanding loans in hard cash at any given time. That's money that protects against bank runs.

Actually, no, it doesn't--because the bank has to have 20% of its outstanding loans in hard cash at any given time. It can't give that money to the depositors, because doing so reduces the reserves faster than it reduces the bank's liability.

Say depositors who collectively account for 10% of your demand deposits all come and ask for their money. You give them half your reserves. But you only reduced your reserve requirement by 10%. That means you need to make up that lost 40% somewhere. Fast.

Imagine there were a law requiring you to have $100 on you at all times. For most people, this initially seems like ample means to cover their daily spending. Then you realize that because you always have to have that $100, you actually need much more than that to take care of your needs.

In theory, the bank regulator can lower the reserve requirements in times of crisis. But as Professor Huizenga pointed out, one thing that regulators do not like to do in times of crisis is announce "Hey, your banks have less cash than they used to!"

The reserve requirements protect the regulator--it limits the loss in the case of a collapse. And that's a worthy goal. But Huizenga argued that it didn't really make the banks all that much sounder. I am still mulling what this implies for regulatory action on investment banking leverage.