Financial Innovation, Leverage, Bubbles and the Distribution of Income

Abstract:     
To prevent financial markets from imploding again, as they did in the fall of 2008, regulators must find ways to limit the amount of “leverage” financial institutions utilize.

Excessive "leverage" means financing with too much debt relative to the amount of equity a firm has. Numerous financial innovations developed in the last few decades have made it easier for firms of all types, but especially financial firms, to finance themselves with debt, or debt-like instruments. Financing with debt is attractive because it can increase the return on equity, so in the years leading up to the financial crisis, firms used unprecedented levels of debt. But excessive leverage swells the financial system as a whole, especially the less regulated parts of the system that have been called a "shadow banking system," increasing risk for the individual firms that use too much debt, and, more importantly, producing systemic instability. Excessive debt exposes the rest of the economy to too much risk by generating asset bubbles, and asset bubbles, in turn, create the illusion that the financial sector is adding substantially more value to the global economy than it really is. The illusion of value creation triggers extraordinary compensation packages that reward the market players whose activities generate the bubble, thus encouraging the use of even more debt.

Instead of tackling leverage head on, Dodd-Frank Wall Street Reform and Consumer Protection Act passed in the summer of 2010 leaves all the important details involved in reining in leverage to regulators. Regulators, in turn, take their cues from the work of a previously rather obscure international committee of bank regulators, the so-called Basel Committee. The Basel Committee has approved capital standards for banks that should reduce leverage, but these will not be fully implemented for eight years, and do not apply to non-bank financial institutions. Moreover, it remains up to bank regulators to interpret and implement these standards.

Number of Pages in PDF File: 89

Keywords: Financial Innovation, Financial Reform, Financial Regulation, Financial Crisis, Leverage, Asset Bubbles, Income Distribution, Shadow Banking System, Money Multiplier, Money Markets, Assets Securitization, Derivatives, Repurchase Agreements, Capital Requirements, Monetary Aggregates, Political

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