Financial Regulation in One Graph
Financial regulation can be confusing -- not to mention its tendency to, well, put people to sleep. But perk up for a moment! Because there's a helpful way for you to think about the different moving parts in financial regulation that are coming from the Federal Reserve.
The Fed is requiring the largest U.S. banks to finance every dollar of their assets, weighted according to their risk, with at least 8 cents of common equity by 2019 -- that's shareholder money, not borrowed funds. The shorthand for this is a common-equity risk-weighted minimum capital ratio of 8 percent, but it's so easy to hand-wave your way to not-really understanding that, it helps to spell it out.
What I think people don't really understand who don't follow financial regulation closely is that the minimum capital ratio, as the Fed wants it, is a nothingburger. That's to say, the relevant banks already meet the requirement.
What matters to banks is the leverage ratio. Banks don't meet it right now. Many, then, will need to increase equity by one to two percentage points of their debt -- which doesn't sound like much until you realize this is in the tens of billions for many banks.
The other reason I think leverage ratios matter is because you can't fudge them, whereas risk weights have a nasty habit of being procyclical -- that is, assets look safer in good times than they actually are over the business cycle. There lies, I think, the best argument for a regulatory approach that combines minima for leverage ratios and risk-weighted capital ratios. And you don't want to go leverage-ratio only, or even put the leverage ratio in the driver's seat, because asset quality does matter.
But the point of this post is to show you that we can put it all together in one graph:
Given an implicit "too-big-to-fail" guarantee, it's in the banks' interest to head northeast on this graph -- that is, to maximize leverage and get aggressive on asset allocation. And if risk weighting was perfect, all we'd need would be that capital requirement. But the point I explained before means that the northwesterly region of the graph, where banks are heavily levered but are invested in high-grade assets, really is not as safe as the graph implies.
In practice, the northwestern region is tempting. The southeast is, as far as I know, pretty irrelevant -- there's no major public-policy concern with banks taking a small amount of money and playing in super-high-risk, high-return investments. And in practice, minimum requirements on asset quality bar that territory off.
Hopefully this graph helps people put financial regulation together in their heads. It helped me when I thought of it.
Note: Some clarifications made after the original posting.
If you're really interested in the math: You could think of the line in this graph as approximating the level curve of a function that measures the total risk of a bank, including the systemic spillovers, which is increasing both in the risk of the average asset (duh) and in the leverage ratio. See the graph on the right if you're not clear what I mean. The intersection of the transparent white plane and the surface is the level curve, which in our case shows the set of possible points with the same risk.