David Moss on Leverage Caps, Rules Versus Discretion for Candy Bar Thieves

Ilan Moscovitz at The Motley Fool writes about a leverage cap as crucial to financial reform, quoting the following from David Moss from Harvard Business School:

Authorizing regulators to limit leverage isn’t enough, because many regulators fell down on the job last time around. As a result, it’s essential that Congress also create a hard cap on leverage that no regulator could weaken. The Collins amendment in the Senate bill sets such a cap for a broad set of financial institutions, including banks, bank holding companies, and systemically significant non-bank institutions. The Speier amendment in the House bill sets a potentially tougher 15-to-1 leverage cap exclusively for systemically significant firms.

I believe these two provisions would work extremely well in combination. I also believe the Speier amendment, which currently defines leverage as ‘debt to equity,’ should be strengthened by using the definition ‘total assets to shareholders’ equity’ instead. This would ensure greater clarity as well as an appropriately tougher standard for the largest — and potentially most dangerous — financial institutions. In combination, Collins and Speier could mark a major step forward and could prove absolutely essential in helping to prevent another crisis from striking in the future.

I think this is good reasoning from all viewpoints. But I also like it for another reason. Think of it in relation to the tendency for our laws, as Chris Hayes discussed about BP, to become more punitive to our poorest citizens and less punitive to businesses. One of the smartest moves the conservatives did in their quest to criminalize poverty was a piece of policy innovation called “mandatory minimum setences.” Even if a judge realizes that a person who stole a third candy bar isn’t a real threat to society, he can’t use his discretion in sentencing and he has to send the person away for the rest of his life.

Is that the case for financial institutions? Look at the “discretion” exercised by the New York Fed against Lehman brothers in the days leading up to the bankruptcy, where they re-ran stress tests over and over until they passed, my favorite example of regulator discretion in the pre-crisis period:

After March 2008 when the SEC and FRBNY began onsite daily monitoring of Lehman, the SEC deferred to the FRBNY to devise more rigorous stress‐testing scenarios to test Lehman’s ability to withstand a run or potential run on the bank. The FRBNY developed two new stress scenarios: “Bear Stearns” and “Bear Stearns Light.” Lehman failed both tests. The FRBNY then developed a new set of assumptions for an additional round of stress tests, which Lehman also failed. However, Lehman ran stress tests of its own, modeled on similar assumptions, and passed. It does not appear that any agency required any action of Lehman in response to the results of the stress testing.

And we only know about this and the “Repo 105” scam that Lehman was doing as a result of the Jenner Block report on Lehman’s bankruptcy. It is clear that Lehman was juking its reporting numbers through Repo 105, and nobody really thinks that there would ever be serious jail time for anyone. Criminal justices with no discretion, and financial regulators with the tools to determine how much punch people get at the end of the party. In a just world, shouldn’t those rules and discretion, the fates of the candy bar thief and the financial industry liar, be reversed?

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