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Tyler Cowen is skeptical that vigilant bondholders can motivate banks to decrease their risk exposure. He’s got a bunch of reasons that I agree with, including regulatory capture, the opacity of bank trading books, and the impossibility of making a no-bailout policy credible. But there’s also this:

The net risk of a bank position is not determined solely by the bank’s portfolio. Say a bank lends money to homeowners and then those homeowners increase their leverage. The bank is now in a riskier position, and de facto a more leveraged position, althoug it’s measured leverage hasn’t gone up a whit.

I think this gets to the heart of things. It’s not practical to micromanage risk-taking in the financial sector, nor is it feasible to eliminate bubbles and bank crises entirely. But I really do believe that we could very substantially reduce the risk of bank crises without affecting the efficiency of legitimate banking operations. The way to do it is with very simple, very blunt leverage restrictions that apply to all financial actors over a certain size: banks, insurance companies, hedge funds, private equity, you name it. If you have assets over, say, $10 billion, then the rules kick in. Strict leverage limits (say, 10:1 or maybe 15:1) based on conservative notions of both assets and capital would be a pretty effective bulwark against excessive risk taking but wouldn’t seriously interfere with the basic asset allocation function of the financial industry.

It wouldn’t be perfect. Nothing is perfect. But if we got obsessed with leverage the same way that, say, the Fed is obsessed with inflation, we could all sleep a lot easier at night. Dodd-Frank and Basel III have gotten us part of the way there, but almost certainly not far enough. Maybe after the next global meltdown we’ll finally do the job right.

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