A Quiet Win for Banks on Borrowing

International regulators just took a dive. America shouldn’t follow their lead.

basel, switzerland with rhine and middle bridge.

Don’t be surprised if the next financial crisis is traced back to the Swiss city of Basel.

Photo by Jules Kitano/iStock/Thinkstock

Basel is a bit of a sleepy town, even by boring Swiss standards. And Basel regulations on bank derivatives holdings is a topic seemingly purpose-designed to put the general public to sleep. And yet, it’s through such dull-sounding mechanisms and obscurantist slogans that the financial sector manages to slip through the fingers of populist outrage and set the stage for future crises.

So people should make no mistake: A boring decision made by boring regulators in a boring town on Sunday deals a significant blow to global financial stability and risks undermining efforts to prevent future banking crises both in the U.S. and in other countries.

The topic at hand is the regulation of bank leverage—a fancy word for debt. A highly leveraged bank is carrying a lot of debt. And any institution of any kind that’s carrying a lot of debt is at high risk of going bust in case of a mishap.

For that reason, one of the most promising regulatory avenues for preventing future bank bailouts is to simply force banks to carry less debt. A less indebted bank is less likely to fail, and if banks don’t fail, then questions of systematic risk and “too big” never arise. But while saying “less debt” is easy, devising precise regulatory language is hard. Since the financial regulation industry is global, it makes sense to try to do this in part through a multilateral process. That process happens in Basel, where this week the regulators decided to take a more bank-friendly view of something called “netting.” 

The idea of netting is more or less: If I owe you $100 and you owe me $80, then I should be allowed to say that I’m only $20 in debt on a net basis, and you owe nothing because the $80 cancels out. Whether that kind of logic really applies to complicated derivatives contracts is something experts dispute, but it’s not a crazy idea.

The issue at hand in Basel was how large a share of their investments banks should be allowed to finance with debt. That’s the leverage ratio. For any given leverage ratio, allowing more netting is friendly to banks. But regulators are writing netting rules in parallel with establishing a leverage ratio: If they wanted to allow more netting simply to allow more netting, they could pair that with a tougher leverage ratio. By allowing more netting without a commensurate rise in the leverage ratio, they’re just allowing more bank debt.

The U.S., thankfully, is free to proceed with tougher rules than the global regulatory standard. But citizens should be on the lookout lest the same bogus arguments that prevailed in Basel carry the day in Congress, the Treasury, and the Federal Reserve.

The big lie of leverage regulations is that a strict rule could “curtail lending” and that laxer ones will “keep lending flowing to the economy.” This is simply not the case. The issue isn’t what kind of lending (or, more broadly, investment) banks can do. It’s how can they finance that lending—specifically, to what extent new lending will have to be financed with new borrowing versus cash. Despite their whining, banks do not actually face serious logistical difficulties in obtaining cash to fund investment. They can get it the same way most companies do: by recycling past profits. In a pinch, they can issue new shares to raise cash, as Facebook did last month. From a shareholder’s viewpoint, it’s better to have past profits flow directly into your pocket as dividends, rather than have them recycled as investments. But there’s no reason you would want a bank to actually forgo a profitable investment opportunity simply because it had to finance it one way rather than another way.

The only universe in which debt financing should lead to more investment than non-debt financing is a universe in which some of the lending being financed is unsound, and creditors are only willing to lend because they’re counting on bailouts.

This is the really important question facing regulators: Do policymakers want to juice investment with taxpayer subsidies? If they do, the sensible approach is to identify something they want to subsidize and commit the money to subsidizing it. Weakening leverage restrictions is a way of creating the subsidy while hiding the ball. Instead of acknowledging the cost upfront and directing subsidies to something worth subsidizing, bank executives will decide what unsound investments to back (Greek government debt, anyone?) and the price will be paid only after a financial crisis strikes. In the meantime, a large and indeterminate share of the subsidy will flow to bank shareholders as dividends and to executives and traders as bonuses.

Victory in pocket, banks will now turn to American regulators and argue that if we get too tough on leverage, our firms will lose “competitiveness” to European banks operating on the Basel standard. It is crucial that regulators not buy this story, and that citizens not let them get away with it. To the extent that European politicians want to help European banks gain global market share by showering them with undeserved regulatory subsidies, this is no loss to the American public. Investment banking isn’t a strategic industry (like, say, aviation) or a large-scale source of middle-class jobs (like automobile manufacturing), where we want to make strategic investments in national champions. Banks won this round, but for the American people, the battle that really matters is the one that will be fought in our own regulatory agencies over the next three months.

Financial services are a necessary part of a thriving economy. But if the governments of France or Germany want their taxpayers to underwrite their provision to the U.S., then we simply should say “thank you,” not race to the bottom with our own subsidies. Tough regulation of bank indebtedness isn’t a panacea, but it is the single most important step we can take toward a world of financial restraint and fewer bailouts. It’s time to start paying attention.