Illustration by Bloomberg View
Illustration by Bloomberg View

U.S. regulators are showing encouraging signs of coming to a crucial understanding: If they want the financial system to be more resilient and beneficial for the economy, they’ll have to make sure the largest banks’ shareholders have more skin in the game.

This week, Federal Reserve officials are expected to vote on new rules for bank capital -- shareholders’ equity and other forms of financing that, as opposed to debt, can absorb losses and prevent insolvency in times of trouble. According to Bloomberg News, U.S. authorities have been considering increasing the requirement to $6 in capital for every $100 in assets, a “leverage ratio” of 6 percent. That’s double the international minimum set by global regulators in Basel, Switzerland. The current U.S. minimum is 4 percent.

A higher leverage ratio would be a welcome step toward strengthening the U.S. banking system. By international accounting standards, five of the country’s largest banks -- Bank of America Corp., Citigroup Inc., JPMorgan Chase & Co., Goldman Sachs Group Inc. and Morgan Stanley -- have, on average, just $3.40 in equity for each $100 in assets. They fund the rest of their combined $13.8 trillion in assets with borrowed money. Such extreme leverage means that a mere 3.4 percent drop in asset values could render them insolvent. This compares with a typical buffer of 8.7 percent for smaller banks, according to data from the Federal Deposit Insurance Corp.

Risk Weights

The leverage ratio has the advantage of being easier to understand, and hence to monitor, than the complex risk-weighted capital ratios that regulators have favored until now. Risk-weighting lets banks use less equity and more debt to finance supposedly safer investments -- for example, a $100,000 subprime mortgage loan might count as $100,000 in assets for capital-adequacy purposes, while $100,000 in government bonds might count as zero. It’s an easily manipulated process that commonly shrinks big institutions’ assets by half or more. The risk adjustments also encourage banks to favor investments with high yields and zero weights -- a market distortion that, among other things, contributed to the euro crisis by prompting European banks to load up on Greek sovereign debt.

Officials at the Federal Reserve have expressed concern about relying too much on the leverage ratio: If it is blind to the types of assets banks hold, they’ll go ahead and load up on the riskiest stuff possible. A bank that invested only in subprime loans, for instance, could look the same as a bank that put all its money in U.S. Treasury bonds. But nobody is suggesting that risk-weighted measures be abolished. Regulators can and should use them as a secondary constraint, to make sure banks aren’t gaming the system.

Equally important is whether requirements for the numerator and denominator in the leverage ratio -- capital divided by assets -- are as demanding as they should be. On capital, FDIC Vice Chairman Tom Hoenig has advocated $10 for each $100 in assets. Economists Anat Admati and Martin Hellwig, as well as research by the Bank of England, have suggested that $20 per $100 would be best for the economy. Given the immense cost of banking crises, it would be prudent to err on the high side.

On the denominator side -- assets -- the big banks have lobbied hard to craft the rules to their advantage. They’ve succeeded in getting regulators to ignore a large portion of their derivatives positions, and they have been pushing to exclude Treasury securities and cash held at the Fed, according to Bloomberg News. Such omissions can cut hundreds of billions of dollars from the banks’ measured assets, making them appear less levered than they really are. Again, such exceptions can create incentives for banks to get too exposed to investments that enjoy special treatment.

Arcane as they may seem, these details matter. A loophole in the definition of assets and several percentage points in a leverage ratio can make the difference between a banking system that takes down the economy and one that guides it intact through the next crisis. This time, regulators must get it right.

To contact the Bloomberg View editorial board: view@bloomberg.net.