By Sheila Bair
Financial Times
August 23, 2010

Of all the lessons learnt in the recent financial crisis, the most fundamental is this: excessive leverage was a pervasive problem that had disastrous consequences for our economy. When large banks and other financial institutions got into trouble, many of them did not have a sufficient equity cushion to weather the storm. This paved the way for major market disruptions, taxpayer bail-outs and massive contractions in credit.

Thankfully, the Basel Committee on Banking Supervision is now moving to correct the problem. Proposed reforms centre on three areas: weeding out hybrid instruments, which confuse debt and equity and weaken the capital structure; adding new capital buffers so deleveraging need not crush lending in a crisis; and placing higher capital charges on riskier derivatives and trading activities.

Crucially, the reforms include an international leverage ratio. This would place a ceiling on overall leverage in good times and bad, while serving as a hard and fast reality check against too-thin capital cushions when models underestimate the risks.

But even as the Basel reforms move toward ratification by leaders of the Group of 20 major economies this autumn, there are the inevitable calls to water them down. A number of industry representatives are claiming that stronger capital requirements will stifle lending, raise the cost of borrowing and derail the still-fragile economic recovery.

For example, a leading trade association that represents many of the world’s largest financial institutions predicts that the Basel capital reforms will raise the cost of bank loans in major industrialized countries by an average of 132 basis points, resulting in a loss of 3.1 per cent in gross domestic product and 9.7m jobs between 2011 and 2015.

Others disagree.

Economists at Harvard and the University of Chicago estimate that boosting capital requirements by as much as 10 percentage points – far more than any increase under discussion – would raise the weighted average cost of bank capital by only 25 to 35 basis points. They also find no evidence to support the notion that the historical march toward higher bank leverage has reduced borrowing costs over time.

These findings are consistent with another recent study by the Bank for International Settlements, which projects that a 2 percentage point increase in the target ratio for tangible common equity would reduce GDP by no more than 0.3 per cent over four years.

This month, the Basel Committee released a report showing that stronger capital and liquidity requirements are likely to result in long-run net benefits in terms of global economic output. Why the difference in opinion? First, an approach that simply multiplies the change in required equity capital by the effective leverage of a bank misses one critical fact. Tax deductible debt financing may be less expensive than equity at the margin. But this differential narrows considerably in a properly regulated world where debt holders stand to lose in the event of a bank failure. Instead, debt holders will demand compensation for the extra risk they must take on when effective leverage rises.

Second, the social costs of excessive leverage must be taken into account when calculating the economic impact of raising capital requirements. During good times, it is politically popular to maintain capital standards below what the market would charge financial institutions on a stand-alone basis. Bankers earn more, credit standards are lowered and the costs of system-wide risk-taking are implicitly borne by the government.

However, this arrangement grows extremely unpopular when boom turns to bust and the taxpayer has to foot the bill. This is why ending the doctrine of too big to fail has been the centerpiece of US regulatory reform.

But the costs go much deeper. During the run-up to the crisis far too much money was directed towards booming, oversupplied property markets. The bust that followed is clear evidence that capital was misallocated and could have been put to more productive use in areas such as energy, infrastructure or the industrial base.

In the wake of the crisis, we continue to measure the collateral damage in terms of foreclosed homes and unemployed workers, both of which number in the millions. It has been both a human tragedy and a colossal waste of economic resources.

The critics of higher capital requirements tend to understate the extent to which equity can be substituted for debt in financing new loans, and fail to account for the social costs created by insufficient capital cushions. So what is really at play here is that some in the industry are arguing their own self-interest. Higher capital requirements mean lower shareholder returns and reduced compensation.

But if financial reform is about anything, it is about better aligning incentives and internalising the costs of leverage and risk-taking. A more rational capital regime that extends across the global financial system is an essential part of these reforms.

Cleaning up bank balance sheets and strengthening the quality and quantity of capital will not be painless. But if we fail to follow through in strengthening bank capital, we risk wasting the capital we already have and exposing the global economy to the onerous and indefensible costs of another financial crisis.