It wasn’t supposed to be this way.
In 2008 Lehman failed, in part because the company was massively leveraged. They had borrowed over 30 times their net equity. When the real estate market tanked, investors were worried that Lehman would owe more than their assets were worth, and rushed to get their cash out. This “run-on-the-bank” led to Lehman’s failure—a major link in the Financial Crisis which caused our Great Recession.
So regulators focused on the leverage ratio—how many assets a bank has compared with how much equity—as a simple way to analyze risk: the more levered, the more risky. Banks deemed systemically important—too big to fail—have to be less levered than the around-the-corner community bank. This will keep our financial system safe–or so the thinking goes.
But now we see that many big banks are “gaming” the rules by selling safe, liquid assets to make room for more risky loans. In order to make their leverage ratios look safer, they’re actually making their balance sheets more risky. Because their liquid investments and cash reserves serve as a buffer in case a liquidity crisis—another “run on the bank”—emerges again.
For every complex problem there is a solution that’s clear, simple, and wrong. That’s one reason why financial regulation needs to be so complex.
Douglas R. Tengdin, CFA
Chief Investment Officer