The significance of leverage in financial crises: what Shakespeare can teach economists and regulators

By Michael Prowse

Who remembers the interest rate that Shylock charged Antonio in the Merchant of Venice? Nobody – but everyone remembers the pound of flesh that was agreed as collateral.

John Geanakoplos, the James Tobin professor of economics at Yale, argues – only half in jest – that Shakespeare had a better understanding of finance 400 years ago than do most regulators today. Shakespeare understood that most loan contracts involve negotiations over two variables, rather than one. The borrower must worry not just about the interest rate demanded but also about the collateral that he has to put up to get a loan at all. Sometimes the collateral demanded is far more significant than the interest rate – as in Antonio’s case.

Mr Geanakoplos prefers to talk about leverage rather than collateral, but they describe the same phenomenon from different perspectives. When banks are confident, they lend a very high proportion of the purchase price of assets. Investors become extremely leveraged because margin requirements are low – in other words investors can purchase real or financial assets with very small down payments. Equivalently, not much collateral is demanded because the value of the assets that banks can repossess in the event of default only just exceeds their loans.

It might seem that Mr Geanakoplos is saying nothing new. Isn’t everyone these days is worrying about collateral or leverage? One of the main goals of the financial legislation now being reconciled in Congress is to raise banks’ capital requirements. International bodies such as G20 and European Union are equally committed to this goal. In fact European banks are complaining bitterly about the large increases in capital proposed by the Basel Committee on Banking Supervision in Switzerland. But an increase in capital requirements is surely simply a demand that financial institutions become less leveraged.

And in the UK, Sir Andrew Large, a former deputy governor of the Bank of England, appears to be thinking along similar lines as Mr Geanakoplos. In a paper published this week by the Centre for the Study of Financial Innovation, he addresses the problem of “systemic risk”. Hitherto regulators have focused on the risk at the level of individual financial institutions, but have mostly failed to consider the inter-linkages between the decisions of seemingly independent institutions. Sir Andrew proposes a “Systemic Risk Committee” housed in the Bank of England whose task would be to prevent the build up of systemic stress. The only plausible instrument, he suggests, is the control of leverage – understood in terms of capital ratios - because this is measurable and closely related to financial instability.

But while there is broad agreement on the role that inadequate bank capital played in the recent financial crisis, Mr Geanakoplos’s theories are less well understood. As he explains in a recent Cowles Foundation Paper*, economists have for decades systematically ignored investors’ leverage – or the adequacy of the down payments they make on asset purchases. The Federal Reserve and other central banks work hard at regulating the interest rate because they assume this is the key variable influencing the demand and supply of credit. But they should also be actively managing the “leverage cycle”, because this plays a crucial, and partly independent, role in the development of financial crises.

During the expansionary phase of business cycles, down payments on asset purchases typically decline sharply as banks allow their borrowers to become ever more leveraged. (At the same time banks lend ever higher multiples of their own capital.) For instance from 2000 to 2007 the required down payment for home purchase in the US fell from about 14 per cent to less than 3 per cent. Financial risk exploded because the value of banks’ collateral exceeded their loans by ever smaller amounts. And progressively less credit-worthy borrowers were sucked into the market. But by 2008, after the bubble had burst, the required down payment had shot back up to about 16 per cent.

Leverage swings are far more violent for financial assets than for housing, which is why Wall Street suffered a melt down. In 2006, says Mr Geanakoplos, it would have been possible for just two individuals – Bill Gates and Warren Buffett – to buy the entire $2.5trillion portfolio of toxic mortgage securities. This is because leverage was so staggeringly high at the peak of the business cycle: to buy the assets they would have needed to make a down payment of only $150bn. By 2009 the value of the toxic mortgage securities had halved. But permissible leverage had plunged: any buyer would have had to put up virtually the entire sum in cash.

Mr Geanakoplos concludes that central banks will never prevent financial crises by managing interest rates alone – because at crucial phases of the economic cycle fluctuations in permissible leverage are far more significant. The fact that interest rates are at their lowest levels in decades does not mean that house purchase is easy because scared banks are demanding much higher collateral rates. People cannot find the cash for the required down payments. But today’s caution is the result of imprudently high leverage before the bubble burst.

To avoid – or mitigate – the severity of financial crises the Fed and other central banks need actively to manage leverage rates throughout the economic cycle. Indeed, the active management must occur during the ebullient phase: although regulators can always impose lower levels of leverage, they cannot demand higher leverage during bad times. You can force a financial institution to make less risky deals but you can hardly force it to make more risky deals, even if that is what is needed during fragile recovery periods.

A debate is underway as to whether the Basel III capital requirements will cripple the current economic recovery. The Institution for International Finance (which represents the world’s top banks) argues that regulators’ timing is wrong. Higher capital ratios will raise the cost of credit for industry and consumers, reduce economic growth and raise unemployment. It reckons that global growth could be cut by 3 percentage points between now and 2015, resulting in the creation of 9 million fewer jobs than if no reforms were implemented. Growth in Europe would be cut more because it depends more heavily on bank credit than either the US or Japan.

The IIF may well be exaggerating the risks. Yet although everyone accepts the need for higher capital ratios in the longer-term, experts disagree over how rapidly they should be built up while confidence remains fragile. If leverage is to be taken as seriously as interest rates as a source of financial instability, the main priority ought to be regulatory discretion. When economies are booming, and banks are getting over-confident, regulators must have the power to force banks to raise more capital, thereby strengthening their balances sheets for the inevitable downturn.

Mr Geanakoplos, in any case, is not just talking about bank capital ratios. He is demanding a comprehensive oversight of leverage in financial markets, so as to prevent systemic crises that arise because individuals and firms buying assets with ludicrously insufficient down payments. He wants the Fed to collect data on leverage for different asset classes from a broad spectrum of investors, including hitherto secretive hedge funds. He wants the actual leverage permitted in market transactions – including for credit default swaps – to become as transparent and public as the data on interest rates. Once the Fed has data on margins (or leverage) for different asset classes and investors, it will finally be able to monitor the evolution of financial risk.

Ultimately, however, transparent data will not be enough. The Fed and other central banks, he argues, need new powers to impose limits on leverage for different classes of security. This is a radical reform proposal but one that governments everywhere ought to take seriously.

*Solving the Present Crisis and Managing the Leverage Cycle. Mr Geanakoplos presented similar arguments at a conference in Washington held last month by the Institute for International Economic Policy, George Washington University.