FINANCIAL LEVERAGE: THE WRONGFULLY ACCUSED CONTRIBUTION TO

THE FINANCIAL CRISIS AND THE IMPROPER REACTION

By Evan Rassman

J.D. Candidate 2014

Submitted in partial fulfillment of the requirements for graduation with

CORPORATE LAW CONCENTRATION

For the degree of

JURIS DOCTRINE

VILLANOVA UNIVERSITY SCHOOL OF LAW

MAY 2014

Note: This article expresses the idea of “a newly proposed rule.” As of April 2014, the FDIC,

OCC, and Federal Reserve voted to enact the proposed leverage ratio going into full effect in

2018. Accordingly, this article changes its position to repeal the new rule before its enactment

rather than to reject the proposal.

I. Introduction

Leverage is a double-edged sword that can be an investor’s best friend, or worst

enemy. Though leverage is the tool used to make many investments worthwhile, its use can be

misconstrued as a dangerous gamble, made notorious by the downfall of the biggest players on

Wall Street in 2008. Financial leverage is often cited as a vulnerability that contributed to the

financial crisis. Concerns over the role of leverage have prompted a renewed focus on the

minimum leverage requirements that the big eight banks must maintain in order to avoid the

crumble of the financial industry.

In order to address the threat of bank failure, regulators in the United States have long

implemented set capital requirements using a non-risk-based leverage ratio. With the hopes of

combating the occurrence of another financial meltdown, regulators in the United States recently

proposed a rule increasing minimum capital requirements to nearly double the leverage ratio

seen in the rest of the world.

Instead of supporting growth by protecting customers and businesses from riskier

banking practices, this intervention will have the reverse effect. The newly proposed rules,

though aimed at preventing future financial crisis, are far too burdensome for financial

institutions to implement and will not successfully protect banks or their customers from failure.

The new regulations should be amended to turn the focus towards allowing market forces to

regulate the market and to promote an emphasis on internal transparency so as to help

shareholders better manage financial risk.

This article illustrates how leverage is used in the financial world, how it is regulated, the

contribution of leverage to the financial crisis, the response to the use of leverage in the financial

markets, the proposed regulations addressing the dangers, an evaluation of whether the proposed

rules will have an effect on the abuse of leverage, and my personal recommendations as to the

regulation of leverage.  

II. Background

What is Leverage?

Leverage is one of the more interesting and difficult concepts to fully grasp in finance,

but it is an important concept to understand as it plays a key role in the investing realm.

Though the use of financial leverage can be quite complex, its definition is actually quite

basic. Simply put, leverage is the use of borrowed funds to purchase assets in hopes of increasing

the potential return of an investment.1 Businesses borrow money from banks through loans and,

in return, pay a fixed interest rate on their debt. These businesses then leverage their debt by

taking that borrowed money and investing it. This is done, of course, with the expectation of

getting a higher return on their investments, enough to cover both their debt owed and to reap a

profit. Commercial banks, for example, are in the business of collecting deposits from customers

and then investing these borrowed funds by issuing loans to people or companies seeking capital.

Since banks commonly pay 1-2 percent interest rates on deposits and the money is loaned out

interest rates of 5-20 percent, it is easy to see how leverage is used to turn a profit. 2

Leverage is essentially a technique used to amplify an investor’s profits, but it cannot be

ignored that financial leverage is a double-edged sword. By borrowing money to invest, one can

grow his profits exponentially versus one who invests merely the amount of capital he has

himself. While the motivation behind financial leverage is to increase return, there is a great deal

of risk involved. As the amount of debt grows, so does the financial leverage because with higher

debt comes the higher amount of interest due. Leverage can be both beneficial and detrimental,

depending on the fact-specific situation. As long as an investment generates a higher return than

the interest rate, then leverage will work in the investor’s favor. The reverse, however, is also

possible.

Just as financial leverage can amplify profits, it can have the same effect on losses. If the

value of your investment drops, and so with it its return. Using leverage in this situation is no

longer a benefit but quickly becomes a liability. The following example demonstrated by Alan

Blinder in his book After the Music Stopped, shows how financial leverage magnifies profit and

loss depending on the performance of an investment and the amount of leverage held:

“Jane, who craves safety, invests $1 million in one year corporate bonds paying 6 percent

interest. At the end of the year, she gets back her $1 million in principle plus $60,000 in

interest. Since what she receives is 6 percent more than what she originally paid, her rate

of return is 6 percent.

John, who takes more risk, commits $1 million of his own money to buy those same

bonds. But he leverages his investment ten times by borrowing another $9 million from a

bank at 3 percent interest—investing the entire $10 million in the bonds. At year’s end,

John gets back his $10 million in principle plus $600,000 in interest, or $10,600,000 in

total. He repays the bank $9 million in principle plus $270,000 in interest. His net return

is $1,330,000 on a $1 million investment. Thus, John’s rate of return is 33 percent.

Suppose the bond falls 5 percent in value during the year, and Jane and John need to sell.

Now Jane has only $950,000 in principle plus the $60,000 in interest, or $1,010,000 in

total for a paltry rate of return of 1 percent. John will get back the $9,500,000 in principle

plus $600,000 in interest, or $10,100,000 in total. But he will still have to pay the bank

$9,270,000 leaving him with only $830,000 of his original $1 million investment. So

John’s rate of return is minus 17 percent.”3

As the example shows, leverage can have tremendous effects of the outcome of an

individual investment as the solvency of the investor is determined by the success of the

underlying investment. A swing in either direction can have massive impacts. That being said,

thorough analysis and research prior to investing will better manage the downsides of leverage.

Use of Leverage by Financial Institutions

The example above demonstrated a straightforward understanding of how leverage can

be used by an individual, however when it comes to leverage used by banks, it get slightly more

complicated. In the world of commercial and institutional banking, leverage commonly occurs

through the use of credit derivatives. There are two methods of leverage with credit derivatives.

(1) Firms can borrow money from outside the system by making loan agreements, accepting

deposits from customers, or borrowing using other financial instruments, or (2) the credit

protection seller does not have to commit funds up front to cover its expected obligations. The

latter method allows the bank to free up capital that the seller can deploy elsewhere, and thus,

does not impact the banks balance sheet.

To summarize how leverage works regarding the nation’s largest banks, take the

following. Suppose a bank with $100 in assets, which have been financed with $3 of capital and

$97 of debt. If the value of the bank's assets falls by $2, the bank can take the loss by writing

down the equity portion. The bank will still be solvent because its assets are worth more than

what it borrowed. But if the value of the assets dropped by $4 instead, the bank would now be

insolvent. It would be unable to repay its debts. 4

The Regulation, and Arguable Deregulation, of Leverage

Like any great power, improper use of leverage could have devastating effects. To

regulate the use of leverage, among other things, the Securities and Exchange Commission

created the Uniform Net Capital Rule, which forms in part the foundation of the securities

industry’s financial responsibility framework.

The main purpose of the net capital rule is to protect securities customers and creditors by

requiring broker-dealers to have sufficient liquid resources on hand at all times to satisfy claims

promptly. This rule helped enhance investor confidence in the financial integrity of the securities

market and in broker-dealers by ensuring that broker-dealers maintain enough liquid assets to not

only satisfy their liabilities to customers, creditors and other broker-dealers, but also to provide a

cushion of liquid assets in excess of liabilities to cover market risks, should they be required to

liquidate.5 This is achieved by requiring broker-dealers to maintain a specified percentage of net

capital in relation to either their collective liabilities, which, in turn, limits a broker-dealer’s

ability to increase its customer commitments only to the extent that their net capital can support

such an increase. 6

In 2004, the SEC made several amendments to the Net Capital Rule, which many

commentators claim to be the deregulatory measures that set the stage for a future crisis.

However the SEC viewed the amendments as an expansion of regulation, aimed at increasing the

protection of investors, stating that “the amendments should help the Commission protect

investors and maintain the integrity of the securities market by improving oversight of broker-

dealers and providing an incentive for broker-dealers to implement strong risk management

practices.7 Furthermore, by supervising the financial stability of the broker-dealer and its

affiliates on a consolidated basis, the Commission may monitor better, and act more quickly in

response to, any risks that affiliates and the ultimate holding company may pose to the broker-

dealer.”8 The amendments brought the parent holding companies of the biggest investment

banks under supervision of the SEC for the first time, adding an additional layer of supervision

where none had existed previously. This meant that the entire company structures of Lehman

Brothers, Bear Stearns, Goldman Sachs, Morgan Stanley, and Merrill Lynch now had to report

financial data to the SEC consistent with the capital adequacy standards for US bank holding

companies.

In a unanimous vote, the SEC amended the Net Capital Rule applying to broker-dealers

in order to “establish a voluntarily method for of computing net capital for certain broker

dealers.”9 Under the amendments, a broker-dealer that maintains certain minimum levels of

tentative net capital and net capital may apply to the Commission for a conditional exemption

from the application of the standard net capital calculation.10 The amendments to the

requirements were intended to decrease regulatory costs for broker-dealers by allowing them to

use their own risk management practices to evaluate their capital needs.

The 2004 rule change allowed certain broker-dealers to stop using the mandated formulas

prescribed by the SEC, and instead, use their own mathematical models to calculate deductions

for different types of securities.11 Essentially, a broker-dealer could increase its net capital for the

same portfolio of assets and liabilities by switching to the new calculation method.12 Now that

they had more capital under their newly implemented formula, the holding company could

transfer capital out of the broker-dealer and into other businesses without having an immediate

effect on the firm’s balance sheet.

The modified rule allowed “a broker-dealer to use the alternative method of computing

net capital only if it maintains tentative net capital of at least $1 billion and net capital of at least

$500 million. If the tentative net capital of a broker-dealer calculating net capital under this

alternative method falls below $5 billion, the broker-dealer must notify the Commission and the

Commission then would consider whether the broker-dealer must take appropriate remedial

action.”13

Just before the amendments were endorsed, changes to the risk weighting of mortgage-

backed securities were in the works. The Federal Reserve had agreed to accept that mortgages

would get a favorable risk weighting of 50%, similar to the built in mortgage bias created by the

original Basel regulations. This risk rating encouraged banks to acquire mortgage-related assets

causing an explosion of issuance of mortgage securities and a huge buildup of mortgage-related

risk on the balance sheet of commercial banks. So when the big Wall Street investment banks

came under the supervision of the SEC, they too took advantage of the less-regulated mortgage-

backed securities and dramatically increased their exposure to the same loans that commercial

banks had been taking on. 14

Therefore, the 2004 amendments to the Net Capital Rule allowed the big Wall Street

investment banks to reduce their chances of violating regulatory thresholds by expanding their

balance sheets with mortgage-backed securities instead of other securities that were more closely

regulated by the SEC. 15

These amendments totally changed the way investment banks operated. Many critics

argue that the installment of the 2004 amendments lifted leverage restrictions and unleashed a

new beast into the marketplace, however that was not the case. The amendments caused a

reorientation of the balance sheets of investment banks toward mortgage-backed securities. The

investment banks now had a regulatory incentive to hold mortgage-securities instead of other

assets.

Just prior to the financial crisis, US banks maintained an average leverage ratio of

eighteen percent.16 US investment banks under new SEC regulation post 2004 moved towards

very high leverage levels of around thirty four percent.17 The 2004 rule modification by the SEC

allowed investment banks to build up higher levels of leverage.18 A commentator on the 2004

rule change, Alan Blinder, refers to this rule change as one of the six contributions to the

financial meltdown, stating, “Before then, leverage of 12 to 1 was typical; afterward, it shot up to

more like 33 to 1.”19 It’s important to note that the 2004 amendments were not a direct

adjustment to leverage ratio requirements, but rather the increased leverage ratios were an

indirect effect of additional regulation imposed on US financial institutions by the SEC.

III. Leverage and the Financial Crisis

Leverage Levels on Wall Street

After the SEC amendment went into effect in 2004, leverage on Wall Street skyrocketed.

Firms such as Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley, and Goldman

Sachs greatly increased their leverage ratios and operated with as much as 40:1 leverage.20

Lehman Brothers in particular was highly overleveraged with a ratio of nearly 40:1 when

they filed for bankruptcy in 2008. The firm borrowed money to invest in a variety of

investments, focusing heavily on mortgage-backed securities; subprime mortgages to be specific.

In doing so, Lehman Brothers increased its leverage ratio from 24:1 in 2003 up to 31:1 in 2007.21

Though this position generated tremendous profits for the firm during the housing boom,

Lehman Brothers had a dangerously small cushion to protect themselves against any drop in

value of their investments. Just a 3-4% decline in value of its assets would decimate the firm’s

equity.22 Essentially, any downturn in the housing market would be catastrophic. Needless to

say, they were not prepared for what happened next.

When the housing bubble burst, Lehman Brothers found themselves in possession of a

massive amount of worthless securities. Due to their leverage position, they were not financially

able to absorb the huge losses sustained by the subprime mortgage crisis. Lehman Brothers was

not able to recover from the upset, and the ensuing chain of events led to the firm’s demise.

Like Lehman Brothers, Bear Stearns found itself in the trenches after the sharp downturn

of the housing market in 2007. They too heavily invested in subprime mortgage-backed

securities, allowing the firm’s leverage ratio to balloon as high as 42:1.23 When the housing

market began to unravel, it set in motion a chain of events that caused the firm to implode.

Again, because they had levered their position so substantially, Bear Stearns was unable to

handle a minor downturn in the housing market, let alone a market crash. The firm suffered

massive losses since they didn’t have ample liquidity to cover their debt obligations.  

As the value of their underlying assets diminished, these firms were unable to absorb the

losses. Lehman went into bankruptcy, Bear Stearns and Merrill lynch were forced into mergers

with J.P. Morgan and Bank of America respectively, and Goldman and Morgan Stanley were

protected by the federal government by becoming holding companies.

It is widely agreed upon that increased leverage, whether rising out of credit derivatives

or otherwise, magnifies the fragility of financial institutions, which was clearly evidenced by

these big investment banks.24 It can be argued that if these firms had greater liquidity by

maintaining a lower leverage ratio, they would not have faced such devastation when the housing

market crashed. While less leverage would have led to lower returns during the housing boom, it

may have prevented the overall collapse of these firms after the bubble burst.

IV. REGULATORY RESPONSE

Response to the Crisis

When the housing market crashed causing a domino effect that devastated America’s

investment firms, the federal government took action in an attempt to force the nation’s largest

banks to comply with minimum leverage requirements in hopes of preventing such catastrophe

from striking again.

Proposed Rule

In the summer of 2013, the three federal bank regulators – the Federal Reserve, Office of

the Comptroller of the Currency, and the Federal Deposit Insurance Corporation – issued a joint

proposal to require the eight biggest bank holding companies to maintain their leverage ratios to

a minimum of 5 percent, while their FDIC–insured bank subsidiaries would have to maintain a

minimum of 6 percent.25 The standard leverage limit for all banks is currently set at 3 percent.

Proponents of the rule assert that the goal is to make the biggest banks less risky and less prone

to fail. The new regulatory requirements allow for a bank to be sanctioned, and therefore swept

into regulatory care before becoming insolvent.

The proposals released last summer further specify that “bank holding companies with

more than $700 billion in consolidated total assets or $10 trillion in assets under custody—

“covered BHCs”—would be required to maintain a tier 1 capital leverage buffer of at least 2

percent above the minimum supplementary leverage ratio requirement of 3 percent, for a total of

5 percent. An insured bank that is a subsidiary of a covered BHC would need to satisfy a 6

percent supplementary leverage ratio threshold to be considered well capitalized for banking

agencies' prompt corrective action regulations.”26 Tier one capital includes money from

common stock, retained earnings, and non-redeemable preferred shares.

The proposal, focusing on the nation’s eight largest banks, states:

“The agencies propose to further increase the leverage capital requirements for the largest, most systemically significant U.S. banking organizations. The NPR applies to any bank holding company (BHC) with more than $700 billion in consolidated total assets or $10 trillion in assets under custody (covered BHC) and any insured depository institution subsidiary of these BHCs. Using these asset thresholds, the NPR currently would apply to the eight largest, most systemically significant U.S. banking organizations.”27 The agencies propose to establish a “well-capitalized” threshold of 6 percent for the

supplementary leverage ratio under the agencies' respective prompt corrective action regulations

for any covered IDI. In addition, the agencies propose to establish a leverage buffer for covered

BHCs, which would require them to maintain at least 2 percentage points above the minimum

supplementary leverage ratio requirement of 3 percent, for a total of 5 percent. Failure to

maintain this buffer would result in limitations on dividend distributions and discretionary bonus

payments. The proposal, if adopted, will take effect on January 1, 2018, concurrent with the 3

percent minimum supplementary leverage ratio requirement in the new capital rule.”28

In addition, Dodd Frank Sections 165 and 171 also seek to govern the minimum asset

requirements. The final rule set by Section 165 states that “US BHCs and FBOs with at least $50

billion in total consolidated assets will be subject to heightened capital, liquidity, risk

management, and stress testing requirements.”29 These requirements will generally take effect

for US BHCs on January 1, 2015, and for FBOs on July 1, 2016.

Providing further guidance, Section 171 of the Act states that:

“The appropriate Federal banking agencies shall establish minimum leverage capital requirements on a consolidated basis for insured depository institutions, depository institution holding companies, and nonbank financial companies supervised by the Board of Governors. The minimum leverage capital requirements established under this paragraph shall not be less than the generally applicable leverage capital requirements, which shall serve as a floor for any capital requirements that the agency may require, nor quantitatively lower than the generally applicable leverage capital requirements that were in effect for insured depository institutions as of the date of enactment of this Act.”30

The enactment of the Dodd-Frank act granted the regulators the authority and

groundwork to implement these minimum leverage requirements.

V. Assessment of Regulatory Response

While increased capital ratios are widely believed to provide an additional margin of

safety to the banking system as they provide a larger capital cushion to absorb losses, requiring

higher capital and leverage ratios are likely to have secondary-order consequences, ranging from

higher borrowing costs for end users of credit, to reduced rates of return on equity for banks and,

in the extreme, to a reduction in investor appetite as suppliers of that equity.31 The newly

imposed rules requiring increased minimal leverage capital requirements will have drastic

secondary effects and will fail to effectively prevent a bank from slipping into financial despair.

First, the new rules fail to address the riskiness of the assets, and thus, promote banks to

invest in the most risky assets in order to obtain returns consistent with last year’s earnings.

Second, the new rule will put domestic banks at a large disadvantage competitively to foreign

banks. Third, the new rule prohibits banks from being able to expand naturally. Fourth, the new

rule destroys the shareholder’s return on investment and decreases the banks appeal to investors.

Fifth, the new rule drastically curtails lending. Sixth, the new rule fails to account for off-balance

sheet assets.

Criticisms of the Newly Imposed Regulations

1. Leverage Ratios do not Differentiate Between Risky and Non-risky Assets.

If the leverage ratio were to be the primary form of capital regulation, it would create a

system that incentivizes the accumulation of riskier assets without requiring more capital against

those risky undertakings, which would in effect counteract the purpose behind the installation of

the leverage ratio requirement. If the leverage ratio becomes the main regulation for bank

capital, the comparison of banks to each other would be meaningless since banks could have

similar leverage ratios yet completely different risk profiles. Because it does not take risk factor

into account, the leverage ratio would not suffice as a capital regulation.

Leverage ratios do not differentiate between liquid, non-risky assets, such as cash, and

high-risk, illiquid instruments such as complex securitization products. By definition leverage

ratios cannot take into account the riskiness of the asset base. For leverage purposes, an asset is

an asset. Leverage on a balance sheet increases risk, but not all risks are equal. The riskiness of

leverage is directly related to the riskiness of the asset.32 Because the leverage ratio disregards

the risk profile of an asset, banks should not take into account for what or to whom they are

lending when calculating their total assets. Therefore, “a bank must reflect the same amount of

capital against a one week US Treasury bill as it does for a ten-year loan to a politically unstable,

fiscally challenged, emerging market country or a loan to a business with a bad credit history.”33

This process is counterintuitive to regulation efforts as it limits the use of risk-reducing

measures. Not all assets have the same risk factor, but the leverage ratio treats each asset as if

they do. Because of this, the correlation of potential loss to available loss absorbency is lost.

Though the imposed leverage ratio would attempt to limit the amount of leverage that a

firm can take on, companies can easily skirt those rules by purchasing riskier assets with the

leverage that they do have. These actions are comparable to “someone responding to gastric

bypass surgery by only eating butter and chocolate truffles.”34 In order to keep profits high,

firms will be forced to invest in riskier assets, which provide a greater return. Again, this would

juxtapose the intent of the leverage ratio as a capital regulation since companies would simply

invest in riskier assets without a consequential increase in capital to compensate for the added

risk.

What’s more, bankers, prompted by the need to comply with the leverage ratio rules, may

become complacent about liquidity buffers.35 The need to earn a profit while maintaining the

leverage ratio mandated by the new regulation could cause bankers to lose sight of the

importance of maintaining liquidity in case of a downturn. Raising capital is a costly and timely

process, and since the new regulation does not require additional capital based on risk of an

asset, bankers will strive to meet the capital amounts as required by the regulation but have no

motivation to exceed that amount. If these processes were to become commonplace in the

banking realm, the results would be catastrophic.

Because the leverage ratio calculation is not based on risk-weighted value of assets, but

rather the book value, this measure cannot be used to draw comparisons between two firms or

banks. Two banks reporting identical leverage ratios, even operating in the same markets, give

investors and analysts no indication of their relative capitalization given their risk profiles. One

bank could be providing home loans to highly rated borrowers with low loan-to-valuation ratios

while the other could be lending in the subprime sector with high loan-to-valuation ratios. Both

banks could have the same sized balance sheet and hence under the leverage ratio would report

the same levels of capital.36 If the leverage ratio were the primary measure of bank’s solvency,

then, despite obvious risk differences between the banks in the aforementioned example, there

would be no indication of the relative riskiness of their operations. The leverage ratio does not

provide a metric for assessing the risk of a business, nor comparing the riskiness of business

models.

Though at the heart of the regulation is the idea that banks will naturally take this risk

into consideration when deciding how to use their capital and determining the return necessary to

achieve maximum profits, the regulations here fail to address the concern of banks investing in

high risk ventures at the markets cost.

2. Higher Leverage Requirements put Domestic Banks at a Disadvantage to Foreign Banks

European banks regulated by Basel III face a much lower leverage requirement than the

5% - 6% that is being proposed in the United States. Under Basel III, banks are only required to

hold capital equal to 3 percent of total assets, and thus are required to hold 2 percent less capital

in comparison to the eight largest financial institutions in the United States. By increasing

leverage requirements here in the US, the appeal of borrowing capital overseas will drastically

rise, effectively stunting our economic recovery.37 If a big eight bank is forced to comply with

higher leverage ratios, they will need to increase their interest rates in order to compensate.

Companies unable to either (1) obtaining funding because of a high risk investment or (2) unable

to afford the interest rate requirement driven by the new ratios, will simply contact Barclays in

the United Kingdom to obtain financing at a lower rate. This increased ratio will completely pull

the big eight banks out of competition, severely damaging their global standing and negatively

affecting their shareholders.

A proponent of the bill argues to this that megabanks in Switzerland, with even higher

capital ratios than those proposed in the United States, have no problem maintaining their

domestic clients, and still manage to generate large quantities of business. This argument,

however, will not hold up in the case of the United States. The appeal of the Swiss market is not

comparable to the domestic market here in the United States for the Swiss market is so miniscule

in comparison and does not seek to compete globally.

JP Morgan’s CEO, Jamie Dimon, showed his concerns relating to global competition if

the bill goes into effect and increases the bank’s required capital. Dimon, who was originally

supportive of regulations increasing the minimum capital ratios states that this proposed bill is

over burdensome to the biggest banks.38 Dimon added that “other details hit investment banking

activity core to U.S. banks hardest because of the threat that Asian banks, in particular, could

take U.S. market share due to the combination of U.S. domestic and global rules.”39 Clearly

there is a concern for remaining competitive on a global scale if the proposed regulations go into

effect. It’s been argued that there is a need for more regulation on the American investment

banking system; however sight cannot be lost on the big picture. It must be made certain that

changes made domestically do not hinder growth internationally.

3. The New Rule Restricts the Bank’s Ability to Expand.

Requiring higher levels of capital against debt held will greatly restrict the ability of

banks to invest in new opportunities by drastically limiting their mode of expansion.

Traditionally, banks expand as they see opportunities and market windows. Due to the

competitive nature of the financial world, little time is allotted to seize these opportunities and

action must be taken immediately in order to take advantage when opportunities arise. Typically,

banks can execute expansion rather rapidly by expanding their balance sheet and increasing their

debt financing when they see a viable opportunity.40 A higher leverage ratio requirement would

restrict this process and inhibit banks’ ability to advance on viable prospects in a timely manner.

Under this new regulation, banks would be unable to expand their balance sheet by financing the

additional debt needed to seize new opportunities as they arise and are instead forced to wait, and

potentially lose out on the opportunity at hand, while they accumulate capital for financing. This

change in procedure will make banks less nimble and unable to productively react to

opportunities in a quick paced and ever changing industry.

It has been argued that the new leverage regulation would seek to monitor this type of

expansion to prevent banks from being spread too thin too quickly; however, since this new

regulation does not does not take into account the asset risk profile of each bank in question, it

cannot successfully be applied to all banks universally. By setting a ceiling for the banks’

leverage on the basis of the size of the respective bank’s capital and its assets, regardless of their

riskiness, it limits the extent to which banks can expand their balance sheets, even for banks

whose operations are considered relatively risk-fee.41 Therefore this regulation would suppress

the growth of even the most stable of institutions and stagnate the growth of the market as a

whole. Use of the leverage ratio for capital regulation would tie the hands of the bank until its

balance sheets reflect the capital needed to balance the added debt for funding the project, even

for low risk and fiscally sound investments. Time is money, and time spent waiting to balance

out the leverage ratio would be costly for any firm. It is irrational to impose this type of

restrictions on bank expansion, especially if risk is not a contributing factor to the regulation.

4. The New Rule Injures Shareholders by Decreasing the Return on Equity.

Naturally, by imposing ample regulation on leverage limits, banks will be forced to raise

additional capital in order to comply with the capital requirements. Higher capital standards will

significantly restrict lending that, based on the new leverage ratio requirements, does not

generate an adequate return on investment.

Raising capital is a very expensive operation. It requires banks to halt issuing dividends,

increase their retained earnings, and issue additional shares of stock. By withholding dividends,

the bank will be able to retain additional capital, however, the longtime shareholders will be hurt

by the failed distribution. Additionally, because of the higher capital requirement, banks will be

forced to issue more shares thus diluting the value of the shares currently outstanding. This

directly injures the shareholders while providing little additional support for the banks fiscal

stability.

Additionally, different tiers of capital demand different levels of return, because they

expose the investor to different levels of risk; i.e. the riskier the investment, the greater the

return. If banks were forced to hold more equity, as the new leverage ratio regulation requires,

that equity would essentially become less risky, consequently creating a lower return to investors

of the bank. In order to appeal to investors, banks need to generate returns that are competitive

with other uses for investor capital.42 Higher capital requirements will make it harder to

generate those returns and thus hinder the ability for banks to attract investors. With the

installment of a leverage ratio, the average credit spreads will go up because banks need to get a

higher return on their lending to maintain the same return on a larger equity base, and for some

borrowers the higher credit spreads will make their businesses no longer profitable.  

Supporters of the new regulations argue that banks should not issue dividends but rather

reinvest earnings back into the banks’ expansion. This argument stems on the idea that a

company’s retained earnings increase the shareholder’s value and thus, shareholders should be

satisfied that their investment is gaining a return identical to that of the banks’ return on assets.

However, with the increased minimum capital holding requirements, the bank is guaranteed to

receive a lower return on its assets since it will no longer be able to invest into as broad of a

market. Since this will decrease the overall return on assets, reinvesting earnings back into the

bank will decrease shareholder earnings, which shows that withholding dividends, in this

instance, is inconsistent with the best interests of the shareholders.

In the end, withholding dividends and diluting existing shareholders in an attempt to raise

capital has a negative effect on shareholders and tends to drive share prices down, thus

counteracting the bank’s capital-raising endeavors.

Proponents of the increased leverage ratio also argue that the capital requirements do not

hinder shareholders, but instead provide them with more confidence that their investment is safe

because of the lower risk associated with the increased capital requirements. This statement is

only true in part. Though a higher capital requirement will lower the risk of insolvency, the

higher capital requirement will not lower the risk of seizure by the regulators. If for some reason

a bank is unable to meet their leverage minimums, the bank will be swept into regulatory control

and the regulators will have complete control over the bank’s operations, may close the bank

entirely, or close the bank for a given portion of time.43 This is will indefinitely result in lower

stock prices, if not destroy the value of the stock all together.

5. The New Rule Curtails Lending.

As it stands now, banks generate a majority of their income from the interest earned on

less than premium grade investments. Imposing this leverage regulation and forcing banks to

lend only to the safest of customers will drastically diminish applicants in the lending pool.

Many projects will be unable to get off the ground and will halt economic development and

innovation. Only established companies with successful track records will be able to easily

obtain funding. Other, riskier ventures will be forced to walk down the dangerous path of

seeking funding through venture capital, private equity, and other management assisted capital

growth methods. These methods are commonly known in the business world for being less stable

than traditional banks, further increasing the odds against the success of start-ups.

Further elaborating on the banks inability to lend to small businesses, though there is a

fine line between what is and is not a prime investment, the new capital requirements will move

the line too far toward rendering the investment as too risky. With the new leverage maximums,

banks that currently lend to risky businesses will be unable to make such loans because the

adjusted returns will be too low to justify the capital required to make them.44 Not all risky

investments are bound to fail and by cutting out the ability for banks to lend only to safe

operations, the banking industry will change dramatically.

An argument can be made that a higher leverage requirement, and thus a higher capital

account, actually promotes banks to increase lending. Though “voluntarily high levels of capital

can indeed encourage lending during a credit crunch, regulatory capital requirements have the

opposite effect” according to an advocate for decreased regulation.45 Due to the fear that

regulatory authorities will seize all banking operations during a credit crunch, the bank in this

situation will have more trouble financing loans during the threatening period. This threat allows

creditors to be fearful of seizure, and thus will be extremely hesitant to issue loans. At the end of

the day, a bank merely needs to retain the ability to have enough capital to stay solvent and

above the regulatory minimum.46

However, in the instance of a bank seizure, the regulating authority seizing the bank will

be forced to pay off creditors with the remaining bank assets. This argument could be construed

to reduce the loss from a bank defaulting on its obligations

6. The New Rule Fails to Include off-Balance Sheet Exposures.

After the crisis, many commentators blamed the exclusion of off-balance sheet exposures

as a major roadblock to the regulators’ ability to monitor the leverage of big banks. Despite these

concerns, the proposed rules fail to take into account the oversight of Special Purpose Entities

and other off-balance sheet assets.47 A Special Purpose Entity, for example, is considered an off-

balance sheet entity because its assets and liabilities are legally separate from the bank and are

not required to be consolidated into the balance sheet of the bank that formed the entity. These

vehicles open the door for banks to manipulate leverage ratios by buying and selling assets

between entities by their own discretion in order to avoid breaching leverage minimums.

In can be argued that by excluding off-balance sheet exposures from the proposed rule,

that the regulators are almost forcing the banks to trend back to their pre-crisis methods of book

keeping, which is most certainly in contradiction of the initiative behind the new regulations.

VI. RECOMMENDATIONS

With the aforementioned criticisms in mind, I believe that a complete overhaul of the

new rule proposals is in order. First, I believe that the market is better fit to regulate bank

leverage than a third party regulator, and thus, the former 3% leverage minimum is fitting.

Secondly, I recommend that the big banks provide transparency to shareholders by disclosing

their current leverage ratio and the riskiness of the assets involved.

The Market is able to Decide if a Bank is Adequately Financed

The market is able to check the financial stability of the institution in two forms outlined

below. In the first form, other financial institutions that typically lend to one another are in a

position to check the financial stability of other firms. In a second sense, the shareholders of a

corporation, through adequate disclosure, are able to assure their company is financially

adequate.

i. Market Checks by Lending Institutions

A static restriction on a dynamic market seems counterintuitive and could cause more

harm than good. The market should be able to decide whether banks are properly leveraged.

Because banks rely entirely on short term lending, the market should decide the fate of these

large banks by simply looking at the balance sheets and determining whether or not a bank is

credit worthy. With a high a leverage ratio, the suspect bank will be unable to obtain financing

due to its risky debt position and thus be unable to fulfill its short-term obligations.

As aforementioned, banks make their income by providing short term funding to

companies and other organizations seeking capital. If a bank is unable to prove its

creditworthiness in order to obtain funding for itself, it will then be unable to provide loans to

customers. If its leverage position restricts the bank from performing the core functions of its

business, an overleveraged bank will be forced to diminish its ratios in order to continue

operations. According to Gary Gorton, lenders in the commercial paper market and other short-

term money markets, like depositors in a bank, place the highest value on safety and liquidity.48

Through this process, the market essentially regulates itself without the need for overcomplicated

and unnecessary oversight.

Additionally, a set leverage ratio is not consistent with constant changes of the market.

Leverage tends to be procyclical by rising in good times, when the confidence of lenders and

borrowers is high, and falling in bad times, when confidence turns to caution.49 By allowing the

market to judge the stability of loans on a bank’s books, the market is able to decide whether or

not the transaction is too risky.

Banks are more familiar with the current lending structures and stability of the market.

Lending structures and ratios are constantly changing. Simply put, the regulators are unable to

adapt quickly enough to keep up with fast paced trends and fully comprehend changes in

practices. Large banking institutions, on the other hand, employ hundreds of people to closely

monitor trends in the market and analyze the risks of the new methods as they develop.

Elaborating on this argument, the eight biggest banks threatened by the proposed rule are

and have much stronger teams of financial analysts, economists, and risk managers than any

branch of the United States government and are much better equipped to monitor changes in the

market. These banks recruit the top students in the top business schools from around the world.

The vast majority of these phenomenal individuals pursue careers with the Big Eight rather than

a career with a regulatory group since the big banks are able to pay top dollar for such skills.

Because of this, these institutions have the best resources available for determining the riskiness

of a loan and the stability of a bank in comparison to federal regulatory oversight.

ii. Market Check by Shareholders

Aside from banks regulating one another, I further recommend that the shareholders of

these big banks thoroughly assess and monitor their investments by requiring these big banks to

disclose their leverage ratios in a simple and straightforward document dedicated solely to the

disclosure of this information. This way, the leverage ratio will not be lost or hidden in the

multitudes of reports and analysis provided to shareholders. By requiring leverage ratio

disclosures in this form, investors, both passive and active, will be better able to assess their risk

standings as well as make informed business decisions. Because shareholders stand behind

creditors in the instance of bankruptcy or insolvency, shareholders will protect their interest in

promoting the solvency and liquidity of the company, which begins with a thorough

understanding of the company’s leverage position.

As it stands now, these big banks are public companies and, as such, are required to

disclose their potential risks in the MD&A section of their 10-K. This disclosure, despite the

importance placed on it by federal regulators, is typically buried deep inside a 10-K. For

example, in Goldman Sachs most recent 10K, they briefly described their leverage ratio on page

113 of their 10-K. Again, I recommend that in addition to disclosing, or hiding, the leverage ratio

within the 10-K, regulators need to require the big banks to issue a simple and concise document

to shareholders describing the leverage ratio and the riskiness of the assets relating to it.

These large financial institutions are some of the most closely followed stocks in the

world. Like with any other company, if a financial analyst finds the bank has too high a leverage

ratio, the shareholders will use their power to make the changes necessary to bring it back down.

Providing further support, many institutional investors hold large amounts of stock in a

company and have great influence over the decisions of the board. If a large fund sees a risky

leverage ratio, the fund could easily dump the stock or go directly to the board to seek change.

Due to the compensation structures of boards of directors and officers of these corporations, the

likelihood of the bank responding to the institutional investors is extremely high.

The Fear that Market Checks do not work until it is too late

Many critics of reducing government regulation on leverage claim that the market check

system does not work until it is too late. One critic of the idea proposed the example of the

market’s check on Lehman Brothers. The market continued to lend to Lehman until several days

before Lehman was forced into bankruptcy. By the time the market realized that Lehman’s

balance sheets were unworthy of lending, the bank was in too deep of debt as it was leveraged

near 40:1.

This argument fails because changing leverage ratio requirements will not prevent this

event from occurring. As stated, Lehman Brothers had an extremely high leverage ratio, which

was merely a side effect of its overinvestment in risky loans. According to the report issued by

Anton Valukas, the bankruptcy examiner for Lehman Brothers, leverage was not the culprit here

but rather “the main reason for Lehman Brothers’ downfall was its imprudent lack of

liquidity.”50 Again, because leverage ratios do not make a distinction between liquid, non-risky

assets and high-risk, illiquid instruments such as complex securitization products, like the assets

held by Lehman at the time of its collapse, it does not make for a sufficient metric for monitoring

the activities of big banks.

By requiring the banks to disclose their leverage ratio and a detailed description of the

assets linked to the ratio, several events would have occurred that direct regulatory oversight

would not cover. First, if, as I recommend, Lehman was forced to disclose to shareholders a

simple explanation of the leverage ratio and the extremely risky assets it had invested in,

financial analyst would have flocked to the news to report the risk long before Lehman was over

leveraged. Furthermore, financial institutions that lent to Lehman would have been quite aware

of their condition and would recommend Lehman decrease their leverage ratio in order to

comply with their own internal risk management measures.

Additionally, many banks continued to lend to Lehman with confidence that a

government bailout would protect their investment in times of default. Bailouts are no longer an

option, which should be a tremendous wake up call to investors. This knowledge should prompt

investors to evaluate the risk of their investments and make a complete and prudent conclusion

before taking action.

VII. CONCLUSION

The financial crisis demonstrated that the U.S. leverage ratios did not prevent the collapse

of 140 banks in 2009 and 157 in 2010. A higher leverage ratio is not the answer. Though it will

provide the bank additional cushion in the instance of a major decrease in assets, we need to be

more concerned with avoiding the decrease in assets and promote investors and lenders to be

aware of risky investments. I am not recommending we abolish all minimums and let the banks

run free to do what they will, I simply find that the new rule places a much greater burden than it

accomplishes in providing a larger cushion in the event of a crash.

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