Monday, March 17, 2014

Self-Indulgent Argument Time: Leverage is a Feature, Not a Bug

Time to pay homage to this blog's silly title and go on a bit of a rant. I'm going to voice what on the face of itself may appear to be an absurd, reactionary promulgation, but here goes: Limits on financial leverage imposed on banks are counter-productive.

In fact, not only have I concluded that limits on leverage are wrong, I'll go one step further: I'm willing to postulate that nine out of every ten people in favor of strict leverage limits haven't really thought through the dynamics of their position, or perhaps are a bit unclear of the parameters of the issue entirely.

Here's the reason why. When all is said and done, "financial intermediation" and "leverage" are actually the same thing. Synonymous. By-words for each other. When a bank accepts a dollar in deposit from a customer and lends $0.90 of it out (keeping $0.10 on reserve at the Fed of course), that increases the bank's leverage, because it has issued a liability in the form of the deposit and acquired an asset with the proceeds in the form of the loan + the reserve it now claims on the Fed. If this leverage- and- risk- multiplying transaction sounds suspiciously like old fashioned "banking," its because it is. Banks borrow funds from net creditors and lend them to net debtors, pocketing the spread between interest paid to the creditors and that charged to the debtors.

Pundits and commentators eager to reign in the "big banks" and Wall Street in general often portray the phenomena of leverage in a far more exotic form, as if it were a fundamentally unsound and dangerous proposition. In the parlance of the cognoscenti, banks "gamble with borrowed money," which is actually the same thing as lending out deposits.

As Alan Greenspan wrote in the memoirs, when considering the implication of an argument, it can help clarify the point if one carries the argument to its logical extreme and see if it makes sense. If the answer to financial stability is strict limits on bank leverage, why not ban leverage entirely? Wealthy shareholders could get together and pool their money into capital funds, and lend it out to borrowers, while accepting no deposits from the common sort of people who presently use banks and thus increase those bank's leverage. The rest of us could resort to stuffing our life savings under the mattress, or bury it in the desert and hope no one finds out. Come to think of it, it makes me wonder if the whole financial regulation movement hasn't been secretly underwritten by the safe manufacturing industry from the very start.

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