Bank Leverage Is A Red Herring

Many offer higher capital and lower leverage requirements as a solution to the problem of the recent banking crisis. However, it is a risk preference problem and it is not a capital or leverage problem. As anyone familiar with financial theory knows, leverage can be placed anywhere in the investment chain to create a higher risk level. Higher leverage is just a way to increase risk and the potential return.

So, if capital is increased at the bank level (lower leverage and lower risk), banks will either invest in riskier products or make safer investment products riskier by incorporating leverage into the product directly or implicitly, such as through embedded options, etc.

Using residential mortgages as an example, their risk is increased by going from 80 percent loan to value to 100 percent loan to value. Additional risk is created by lending to lower credit worthy borrowers.

When the mortgages are packaged as investment products, borrowed funds can be used to increase the value of mortgages in the product so that the total mortgage value exceeds the equity investment in the product, which increases their riskiness. The investors in these leveraged products can borrow funds themselves to increase their equity investment in the leverage products, further increasing the risk to the investors.

The investor's risk preference ultimately determines the amount of risk in the invested products. There are too many ways to increase risk. Regulations and regulatory supervision will not stop excessive risk from occurring if that is what the bank or any other investor desires.

It is a rehash of the old Modigliani-Miller problem about the optimal capital structure. A bank with low leverage can invest in riskier products to achieve the same total institutional risk that higher leverage would achieve. Despite the regulators' attempt to prevent increased risk, an institution with a higher risk tolerance will find ways to invest in products that match its risk profile. The risk to the institution will not be lower with higher capital amounts.

As Arnold Kling stated, "the problem was not a gap in regulatory structure." What would cause financial institutions to take on so much risk that the continued existence of the entire institution was in jeopardy?

Moral hazard and incentive compensation themselves cannot explain the institutional behavior. Participants, many of whom had restricted company stock, risked too much of their own personal wealth, careers and reputations for the bonus compensation structure to be the answer. Furthermore, many of the investors, including the investment and commercial banks, are too sophisticated not to have understood the risk, despite the credit rating agencies' stamp of approval and their post mortem statements.

While there are many "expert" answers proffered, none offer an adequate explanation of why institutions took on so much risk. Many sophisticated investors and financial institutions either misread the risk in the market or intended to take on excessive risk. Both are troubling and not easily fixed.