Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

On Tuesday, federal banking regulators opened an important new phase of the debate on how safe very large financial institutions should become. The next round of argument will be intense; the focus has shifted to the specific and high-stakes question of how much leverage big banks can have – i.e., how much of each dollar on their balance sheet they should be allowed to fund with debt rather than with equity.

Today's Economist Perspectives from expert contributors.

The people who run global megabanks would rather fund them with relatively more debt and less equity. Equity absorbs losses, but these very large companies are seen as too big to fail – so they benefit from implicit government guarantees. A higher degree of leverage – meaning more debt and less equity – means more upside for the people who run banks, while the greater downside risks are someone else’s problem (the central bank, the taxpayer or, more broadly, you).

A key regulator on this issue is the Federal Deposit Insurance Corporation, which was created in 1933 to insure banking deposits – and hence serves as a crucial underpinning for public confidence in the financial system. The F.D.I.C. has a responsibility to financial institutions that pay insurance premiums; the goal is to avoid using federal tax dollars, so any losses are absorbed by the insurance fund.

Small banks have been pointing out for some time that while they pay a great deal in insurance premiums, the main dangers in the financial system arise from the excessive leverage and more generally mismanaged risk-taking of big banks. The Independent Community Bankers of America has an excellent set of materials on ending too big to fail, in which it asserts,

The U.S. will not have a robust and truly competitive market for financial services until the too-big-to-fail problem is definitively resolved.



I highly recommend the white paper put out by the association on this issue.

On the F.D.I.C. board, the strongest voices for limiting leverage by big banks have been the two Republican appointees, Thomas Hoenig and Jeremiah Norton. If either were in charge, my guess is that we would end up with a leverage ratio closer to 10 percent than 5 percent. (The way “leverage ratio” is defined in this debate is confusing – a higher ratio actually means more equity is required relative to debt, so a higher ratio implies less debt and a safer system, all other things being equal. As with all discussions of financial transactions, you need to check the fine print.)

Martin J. Gruenberg, the chairman of the F.D.I.C., has also been good on the leverage issue (I’m a member of the F.D.I.C.’s Systemic Resolution Advisory Committee, but I’m not involved in any of their work on bank capital or leverage). In its official announcement of the proposed rule-making, the F.D.I.C. said:

A strong capital base at the largest, most systemically significant U.S. banking organizations is particularly important because capital shortfalls at these institutions have the potential to result in significant adverse economic consequences and contribute to systemic distress both domestically and internationally. Higher capital standards for these institutions will place additional private capital at risk before the federal deposit insurance fund and the federal government’s resolution mechanisms would be called upon, and reduce the likelihood of economic disruptions caused by problems at these institutions.

The problem appears to be the board of governors of the Federal Reserve Board, which once again appears to have given in to industry pressure.

The big banks swear up and down that to subject them to a tougher leverage requirement (less debt, more equity for them) would somehow derail the economic recovery or even crater the global economy.

This is a complete fabrication – read the independent bankers’ report or look at the recent paper by Anat Admati and Martin Hellwig, “The Parade of the Bankers’ New Clothes Continues: 23 Flawed Claims Debunked,” which goes in detail through all the fallacious arguments that have surfaced in response to their recent book, “The Bankers’ New Clothes.”

Plenty of smaller banks are willing and able to lend to companies and individuals in the real (i.e., nonfinancial) economy. The bankers’ association, Mr. Hoenig, Mr. Norton and other current and former officials (such as Sheila Bair, the former head of the F.D.I.C.) want to end the subsidies received by too-big-to-fail banks. Create an even playing field by removing – or at least reducing – the advantages enjoyed by the very largest banks, which benefit not just from an implicit subsidy but can borrow on advantageous terms from the central bank and obtain other privileged forms of official support not available to anyone else.

The Fed’s board, unfortunately, has sided with the megabanks, resisting attempts by the F.D.I.C. to set an interim final rule on leverage (which would be more definite and harder to lobby than the proposal put on the table) and pushing back against the idea that the leverage ratio for megabanks should be at least 6 percent.

So what we have instead is a proposal, which will now receive comments, for the leverage ratio to be 5 percent for the largest eight or so financial companies (at the holding company level; debt levels would need to be slightly lower at insured bank subsidiaries). At the same time, this does present an opportunity. There is a split of opinion within officialdom, and the F.D.I.C. still wants to do the right thing – put a tougher cap on leverage. The comment period can cut both ways; representatives of the big banks will argue for 4 percent or even 3 percent (the minimum under the Basel III capital accord), but those more concerned with financial stability can still push for 10 percent or even higher (i.e., allowing less debt and insisting on more equity).

The F.D.I.C. has made some progress but now needs help. With encouragement from their constituents, Congressional representatives might be persuaded to push for tougher limits on the leverage at big banks.