The Compelling Case for Stronger and More Effective Leverage Regulation in Banking

Abstract

Excessive leverage (indebtedness) in banking endangers the public and distorts the economy. Yet current and proposed regulations only tweak previous regulations that failed to provide financial stability. This paper discusses the forces that have led to this situation, some of which appear to be misunderstood. The benefits to society of requiring that financial institutions use significantly more equity funding than the status quo are large, while any costs are entirely private and due to banks' ability to shift some of their costs to others when they use debt. Without quantitative analysis, I outline improved regulations and how they can be implemented.

Keywords: capital regulation, financial institutions, capital structure, bank equity, owner and shareholder equity

JEL Classification: G21, G28, G32, G38, H81, K23