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The Federal Reserve is cracking down on giant banks' reckless borrowing

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  1. A new proposed Federal Reserve regulation will put tougher limits on how much debt (and therefore risk) the eight largest banks in America can carry.
  2. This new rule is, by design, similar to — but tougher than — the international regulation negotiated in Basel, Switzerland.
  3. Even though the formal rule is tougher, seven of the eight banks are already in compliance with it — JP Morgan will need about $22 billion in additional capital.
  4. Banks have until 2019 to comply, so JP Morgan can easily raise the needed $22 billion out of retained profits between then and now. This just means reduced payouts to shareholders.

Why bank leverage matters

These regulations relate to the amount of "capital" a bank needs to have, which is also sometimes described as capping the amount of "leverage" the bank can have. Those are two different ways of saying that the rule limits borrowing. It says that for every $X in investments that a bank makes, there is a maximum amount that can be financed with debt. Debt-financed investments are appealing to bank shareholders because they're more profitable when they pay off, but they're riskier for the economy because they make it more likely that the bank will go bust.

Thinkers led by Stanford University's Anat Admati have been pushing for tougher bank leverage rules for years now as the best way to prevent future bank bailouts. And the Federal Reserve has been listening and promulgating tougher rules, without going as far as Admati wants.

Rather than offer a simple, broad, one-size-fits-all leverage rule, the Fed is basing the regulation on several factors. One is simply the size of the banks — the bigger you are, the more stringent the rule. The other is the scope of the operation — banks that have complicated structures and lots of overseas dealings face a tougher rule. The last is the nature of your debt-funding. If you rely more on very short-term debt, you face a tougher rule. The point in all cases is that really big banks, very globalized banks, and banks with a lot of short-term debt are subject to bigger risks. A limit on leverage minimizes risk, so the riskier banks face a tougher rule.

The competitiveness criticism

On their own behalf, America's banks argue that it's short-sighted to make them follow a tougher rule than their international rivals. They say that these rules will mean lost business and lost competitiveness for the American financial services industry.

Admati says that this is nonsense. That offering banks bailouts when they go bust without restricting borrowing in good times amounts to a kind of subsidy. Banks are proposing, in essence, that the US and Europe get into a competition to see who can do the most to subsidize risky banking. That might make sense if risky banking were some kind of important social good, but since it isn't it's perverse to worry about competitiveness.

In reality, however, it's actually reasonably common for countries to seek competitiveness through business subsidies. Much of the political controversy over the Export-Import Bank or global trade negotiations about agricultural policy take this form. Whether you find the banks' specific competitiveness argument persuasive will hinge in part on your view of the larger question around subsidies and competitiveness in general.

Are the rules tough enough?

On the other side are the continuing chorus of critics who hold that the current regulatory framework remains far too permissive.

The generally conservative economist John Cochrane has proposed that we ban bank borrowing altogether (and in exchange eliminate many other kinds of bank regulations) — an idea that's circulated on-and-off in academic circles for over a century but rarely gained political momentum. Senators Sherrod Brown (D-Ohio) and David Vitter (R-Louisiana) have proposed legislation that would have the same general structure as the Fed's rules, but bind more severely and likely encourage the largest banks to split themselves up.

What's next?

The rule now heads for a comment period in which lobbyists for the relevant banks will get a chance to try to persuade the Fed to change its tune. Big banks will try to get it watered-down, while representatives of smaller banks may advocate for a tougher rule. The general trend since the financial crisis has been for the comment-and-lobbying phase to result in rules getting laxer, but the Fed has been a partial exception to this trend and has often surprised people with the strength of its rulemaking.