1. FINANCIAL LEVERAGE: THE WRONGFULLY ACCUSED CONTRIBUTION TO
THE FINANCIAL CRISIS AND THE IMPROPER REACTION
By
Evan Rassman
J.D. Candidate 2014
Submitted in partial fulfillment of the requirements for graduation with
CORPORATE LAW CONCENTRATION
For the degree of
JURIS DOCTRINE
VILLANOVA UNIVERSITY SCHOOL OF LAW
MAY 2014

2. Note: This article expresses the idea of “a newly proposed rule.” As of April 2014, the FDIC,
OCC, and Federal Reserve voted to enact the proposed leverage ratio going into full effect in
2018. Accordingly, this article changes its position to repeal the new rule before its enactment
rather than to reject the proposal.
I. Introduction
Leverage is a double-edged sword that can be an investor’s best friend, or worst
enemy. Though leverage is the tool used to make many investments worthwhile, its use can be
misconstrued as a dangerous gamble, made notorious by the downfall of the biggest players on
Wall Street in 2008. Financial leverage is often cited as a vulnerability that contributed to the
financial crisis. Concerns over the role of leverage have prompted a renewed focus on the
minimum leverage requirements that the big eight banks must maintain in order to avoid the
crumble of the financial industry.
In order to address the threat of bank failure, regulators in the United States have long
implemented set capital requirements using a non-risk-based leverage ratio. With the hopes of
combating the occurrence of another financial meltdown, regulators in the United States recently
proposed a rule increasing minimum capital requirements to nearly double the leverage ratio
seen in the rest of the world.
Instead of supporting growth by protecting customers and businesses from riskier
banking practices, this intervention will have the reverse effect. The newly proposed rules,
though aimed at preventing future financial crisis, are far too burdensome for financial
institutions to implement and will not successfully protect banks or their customers from failure.
The new regulations should be amended to turn the focus towards allowing market forces to
regulate the market and to promote an emphasis on internal transparency so as to help

3. shareholders better manage financial risk.
This article illustrates how leverage is used in the financial world, how it is regulated, the
contribution of leverage to the financial crisis, the response to the use of leverage in the financial
markets, the proposed regulations addressing the dangers, an evaluation of whether the proposed
rules will have an effect on the abuse of leverage, and my personal recommendations as to the
regulation of leverage.
II. Background
What is Leverage?
Leverage is one of the more interesting and difficult concepts to fully grasp in finance,
but it is an important concept to understand as it plays a key role in the investing realm.
Though the use of financial leverage can be quite complex, its definition is actually quite
basic. Simply put, leverage is the use of borrowed funds to purchase assets in hopes of increasing
the potential return of an investment.1 Businesses borrow money from banks through loans and,
in return, pay a fixed interest rate on their debt. These businesses then leverage their debt by
taking that borrowed money and investing it. This is done, of course, with the expectation of
getting a higher return on their investments, enough to cover both their debt owed and to reap a
profit. Commercial banks, for example, are in the business of collecting deposits from customers
and then investing these borrowed funds by issuing loans to people or companies seeking capital.
Since banks commonly pay 1-2 percent interest rates on deposits and the money is loaned out
interest rates of 5-20 percent, it is easy to see how leverage is used to turn a profit. 2
Leverage is essentially a technique used to amplify an investor’s profits, but it cannot be
ignored that financial leverage is a double-edged sword. By borrowing money to invest, one can
grow his profits exponentially versus one who invests merely the amount of capital he has

4. himself. While the motivation behind financial leverage is to increase return, there is a great deal
of risk involved. As the amount of debt grows, so does the financial leverage because with higher
debt comes the higher amount of interest due. Leverage can be both beneficial and detrimental,
depending on the fact-specific situation. As long as an investment generates a higher return than
the interest rate, then leverage will work in the investor’s favor. The reverse, however, is also
possible.
Just as financial leverage can amplify profits, it can have the same effect on losses. If the
value of your investment drops, and so with it its return. Using leverage in this situation is no
longer a benefit but quickly becomes a liability. The following example demonstrated by Alan
Blinder in his book After the Music Stopped, shows how financial leverage magnifies profit and
loss depending on the performance of an investment and the amount of leverage held:
“Jane, who craves safety, invests $1 million in one year corporate bonds paying 6 percent
interest. At the end of the year, she gets back her $1 million in principle plus $60,000 in
interest. Since what she receives is 6 percent more than what she originally paid, her rate
of return is 6 percent.
John, who takes more risk, commits $1 million of his own money to buy those same
bonds. But he leverages his investment ten times by borrowing another $9 million from a
bank at 3 percent interest—investing the entire $10 million in the bonds. At year’s end,
John gets back his $10 million in principle plus $600,000 in interest, or $10,600,000 in
total. He repays the bank $9 million in principle plus $270,000 in interest. His net return
is $1,330,000 on a $1 million investment. Thus, John’s rate of return is 33 percent.

5. Suppose the bond falls 5 percent in value during the year, and Jane and John need to sell.
Now Jane has only $950,000 in principle plus the $60,000 in interest, or $1,010,000 in
total for a paltry rate of return of 1 percent. John will get back the $9,500,000 in principle
plus $600,000 in interest, or $10,100,000 in total. But he will still have to pay the bank
$9,270,000 leaving him with only $830,000 of his original $1 million investment. So
John’s rate of return is minus 17 percent.”3
As the example shows, leverage can have tremendous effects of the outcome of an
individual investment as the solvency of the investor is determined by the success of the
underlying investment. A swing in either direction can have massive impacts. That being said,
thorough analysis and research prior to investing will better manage the downsides of leverage.
Use of Leverage by Financial Institutions
The example above demonstrated a straightforward understanding of how leverage can
be used by an individual, however when it comes to leverage used by banks, it get slightly more
complicated. In the world of commercial and institutional banking, leverage commonly occurs
through the use of credit derivatives. There are two methods of leverage with credit derivatives.
(1) Firms can borrow money from outside the system by making loan agreements, accepting
deposits from customers, or borrowing using other financial instruments, or (2) the credit
protection seller does not have to commit funds up front to cover its expected obligations. The
latter method allows the bank to free up capital that the seller can deploy elsewhere, and thus,
does not impact the banks balance sheet.
To summarize how leverage works regarding the nation’s largest banks, take the
following. Suppose a bank with $100 in assets, which have been financed with $3 of capital and
$97 of debt. If the value of the bank's assets falls by $2, the bank can take the loss by writing

6. down the equity portion. The bank will still be solvent because its assets are worth more than
what it borrowed. But if the value of the assets dropped by $4 instead, the bank would now be
insolvent. It would be unable to repay its debts. 4
The Regulation, and Arguable Deregulation, of Leverage
Like any great power, improper use of leverage could have devastating effects. To
regulate the use of leverage, among other things, the Securities and Exchange Commission
created the Uniform Net Capital Rule, which forms in part the foundation of the securities
industry’s financial responsibility framework.
The main purpose of the net capital rule is to protect securities customers and creditors by
requiring broker-dealers to have sufficient liquid resources on hand at all times to satisfy claims
promptly. This rule helped enhance investor confidence in the financial integrity of the securities
market and in broker-dealers by ensuring that broker-dealers maintain enough liquid assets to not
only satisfy their liabilities to customers, creditors and other broker-dealers, but also to provide a
cushion of liquid assets in excess of liabilities to cover market risks, should they be required to
liquidate.5 This is achieved by requiring broker-dealers to maintain a specified percentage of net
capital in relation to either their collective liabilities, which, in turn, limits a broker-dealer’s
ability to increase its customer commitments only to the extent that their net capital can support
such an increase. 6
In 2004, the SEC made several amendments to the Net Capital Rule, which many
commentators claim to be the deregulatory measures that set the stage for a future crisis.
However the SEC viewed the amendments as an expansion of regulation, aimed at increasing the
protection of investors, stating that “the amendments should help the Commission protect
investors and maintain the integrity of the securities market by improving oversight of broker-

7. dealers and providing an incentive for broker-dealers to implement strong risk management
practices.7 Furthermore, by supervising the financial stability of the broker-dealer and its
affiliates on a consolidated basis, the Commission may monitor better, and act more quickly in
response to, any risks that affiliates and the ultimate holding company may pose to the broker-dealer.”
8 The amendments brought the parent holding companies of the biggest investment
banks under supervision of the SEC for the first time, adding an additional layer of supervision
where none had existed previously. This meant that the entire company structures of Lehman
Brothers, Bear Stearns, Goldman Sachs, Morgan Stanley, and Merrill Lynch now had to report
financial data to the SEC consistent with the capital adequacy standards for US bank holding
companies.
In a unanimous vote, the SEC amended the Net Capital Rule applying to broker-dealers
in order to “establish a voluntarily method for of computing net capital for certain broker
dealers.”9 Under the amendments, a broker-dealer that maintains certain minimum levels of
tentative net capital and net capital may apply to the Commission for a conditional exemption
from the application of the standard net capital calculation.10 The amendments to the
requirements were intended to decrease regulatory costs for broker-dealers by allowing them to
use their own risk management practices to evaluate their capital needs.
The 2004 rule change allowed certain broker-dealers to stop using the mandated formulas
prescribed by the SEC, and instead, use their own mathematical models to calculate deductions
for different types of securities.11 Essentially, a broker-dealer could increase its net capital for the
same portfolio of assets and liabilities by switching to the new calculation method.12 Now that
they had more capital under their newly implemented formula, the holding company could

8. transfer capital out of the broker-dealer and into other businesses without having an immediate
effect on the firm’s balance sheet.
The modified rule allowed “a broker-dealer to use the alternative method of computing
net capital only if it maintains tentative net capital of at least $1 billion and net capital of at least
$500 million. If the tentative net capital of a broker-dealer calculating net capital under this
alternative method falls below $5 billion, the broker-dealer must notify the Commission and the
Commission then would consider whether the broker-dealer must take appropriate remedial
action.”13
Just before the amendments were endorsed, changes to the risk weighting of mortgage-backed
securities were in the works. The Federal Reserve had agreed to accept that mortgages
would get a favorable risk weighting of 50%, similar to the built in mortgage bias created by the
original Basel regulations. This risk rating encouraged banks to acquire mortgage-related assets
causing an explosion of issuance of mortgage securities and a huge buildup of mortgage-related
risk on the balance sheet of commercial banks. So when the big Wall Street investment banks
came under the supervision of the SEC, they too took advantage of the less-regulated mortgage-backed
securities and dramatically increased their exposure to the same loans that commercial
banks had been taking on. 14
Therefore, the 2004 amendments to the Net Capital Rule allowed the big Wall Street
investment banks to reduce their chances of violating regulatory thresholds by expanding their
balance sheets with mortgage-backed securities instead of other securities that were more closely
regulated by the SEC. 15
These amendments totally changed the way investment banks operated. Many critics
argue that the installment of the 2004 amendments lifted leverage restrictions and unleashed a

9. new beast into the marketplace, however that was not the case. The amendments caused a
reorientation of the balance sheets of investment banks toward mortgage-backed securities. The
investment banks now had a regulatory incentive to hold mortgage-securities instead of other
assets.
Just prior to the financial crisis, US banks maintained an average leverage ratio of
eighteen percent.16 US investment banks under new SEC regulation post 2004 moved towards
very high leverage levels of around thirty four percent.17 The 2004 rule modification by the SEC
allowed investment banks to build up higher levels of leverage.18 A commentator on the 2004
rule change, Alan Blinder, refers to this rule change as one of the six contributions to the
financial meltdown, stating, “Before then, leverage of 12 to 1 was typical; afterward, it shot up to
more like 33 to 1.”19 It’s important to note that the 2004 amendments were not a direct
adjustment to leverage ratio requirements, but rather the increased leverage ratios were an
indirect effect of additional regulation imposed on US financial institutions by the SEC.
III. Leverage and the Financial Crisis
Leverage Levels on Wall Street
After the SEC amendment went into effect in 2004, leverage on Wall Street skyrocketed.
Firms such as Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley, and Goldman
Sachs greatly increased their leverage ratios and operated with as much as 40:1 leverage.20
Lehman Brothers in particular was highly overleveraged with a ratio of nearly 40:1 when
they filed for bankruptcy in 2008. The firm borrowed money to invest in a variety of
investments, focusing heavily on mortgage-backed securities; subprime mortgages to be specific.
In doing so, Lehman Brothers increased its leverage ratio from 24:1 in 2003 up to 31:1 in 2007.21

10. Though this position generated tremendous profits for the firm during the housing boom,
Lehman Brothers had a dangerously small cushion to protect themselves against any drop in
value of their investments. Just a 3-4% decline in value of its assets would decimate the firm’s
equity.22 Essentially, any downturn in the housing market would be catastrophic. Needless to
say, they were not prepared for what happened next.
When the housing bubble burst, Lehman Brothers found themselves in possession of a
massive amount of worthless securities. Due to their leverage position, they were not financially
able to absorb the huge losses sustained by the subprime mortgage crisis. Lehman Brothers was
not able to recover from the upset, and the ensuing chain of events led to the firm’s demise.
Like Lehman Brothers, Bear Stearns found itself in the trenches after the sharp downturn
of the housing market in 2007. They too heavily invested in subprime mortgage-backed
securities, allowing the firm’s leverage ratio to balloon as high as 42:1.23 When the housing
market began to unravel, it set in motion a chain of events that caused the firm to implode.
Again, because they had levered their position so substantially, Bear Stearns was unable to
handle a minor downturn in the housing market, let alone a market crash. The firm suffered
massive losses since they didn’t have ample liquidity to cover their debt obligations.
As the value of their underlying assets diminished, these firms were unable to absorb the
losses. Lehman went into bankruptcy, Bear Stearns and Merrill lynch were forced into mergers
with J.P. Morgan and Bank of America respectively, and Goldman and Morgan Stanley were
protected by the federal government by becoming holding companies.
It is widely agreed upon that increased leverage, whether rising out of credit derivatives
or otherwise, magnifies the fragility of financial institutions, which was clearly evidenced by
these big investment banks.24 It can be argued that if these firms had greater liquidity by

11. maintaining a lower leverage ratio, they would not have faced such devastation when the housing
market crashed. While less leverage would have led to lower returns during the housing boom, it
may have prevented the overall collapse of these firms after the bubble burst.
IV. REGULATORY RESPONSE
Response to the Crisis
When the housing market crashed causing a domino effect that devastated America’s
investment firms, the federal government took action in an attempt to force the nation’s largest
banks to comply with minimum leverage requirements in hopes of preventing such catastrophe
from striking again.
Proposed Rule
In the summer of 2013, the three federal bank regulators – the Federal Reserve, Office of
the Comptroller of the Currency, and the Federal Deposit Insurance Corporation – issued a joint
proposal to require the eight biggest bank holding companies to maintain their leverage ratios to
a minimum of 5 percent, while their FDIC–insured bank subsidiaries would have to maintain a
minimum of 6 percent.25 The standard leverage limit for all banks is currently set at 3 percent.
Proponents of the rule assert that the goal is to make the biggest banks less risky and less prone
to fail. The new regulatory requirements allow for a bank to be sanctioned, and therefore swept
into regulatory care before becoming insolvent.
The proposals released last summer further specify that “bank holding companies with
more than $700 billion in consolidated total assets or $10 trillion in assets under custody—
“covered BHCs”—would be required to maintain a tier 1 capital leverage buffer of at least 2
percent above the minimum supplementary leverage ratio requirement of 3 percent, for a total of

12. 5 percent. An insured bank that is a subsidiary of a covered BHC would need to satisfy a 6
percent supplementary leverage ratio threshold to be considered well capitalized for banking
agencies' prompt corrective action regulations.”26 Tier one capital includes money from
common stock, retained earnings, and non-redeemable preferred shares.
The proposal, focusing on the nation’s eight largest banks, states:
“The agencies propose to further increase the leverage capital requirements for the
largest, most systemically significant U.S. banking organizations. The NPR applies to
any bank holding company (BHC) with more than $700 billion in consolidated total
assets or $10 trillion in assets under custody (covered BHC) and any insured depository
institution subsidiary of these BHCs. Using these asset thresholds, the NPR currently
would apply to the eight largest, most systemically significant U.S. banking
organizations.”27
The agencies propose to establish a “well-capitalized” threshold of 6 percent for the
supplementary leverage ratio under the agencies' respective prompt corrective action regulations
for any covered IDI. In addition, the agencies propose to establish a leverage buffer for covered
BHCs, which would require them to maintain at least 2 percentage points above the minimum
supplementary leverage ratio requirement of 3 percent, for a total of 5 percent. Failure to
maintain this buffer would result in limitations on dividend distributions and discretionary bonus
payments. The proposal, if adopted, will take effect on January 1, 2018, concurrent with the 3
percent minimum supplementary leverage ratio requirement in the new capital rule.”28
In addition, Dodd Frank Sections 165 and 171 also seek to govern the minimum asset
requirements. The final rule set by Section 165 states that “US BHCs and FBOs with at least $50
billion in total consolidated assets will be subject to heightened capital, liquidity, risk
management, and stress testing requirements.”29 These requirements will generally take effect
for US BHCs on January 1, 2015, and for FBOs on July 1, 2016.
Providing further guidance, Section 171 of the Act states that:

13. “The appropriate Federal banking agencies shall establish minimum leverage capital
requirements on a consolidated basis for insured depository institutions, depository
institution holding companies, and nonbank financial companies supervised by the Board
of Governors. The minimum leverage capital requirements established under this
paragraph shall not be less than the generally applicable leverage capital requirements,
which shall serve as a floor for any capital requirements that the agency may require, nor
quantitatively lower than the generally applicable leverage capital requirements that were
in effect for insured depository institutions as of the date of enactment of this Act.”30
The enactment of the Dodd-Frank act granted the regulators the authority and
groundwork to implement these minimum leverage requirements.
V. Assessment of Regulatory Response
While increased capital ratios are widely believed to provide an additional margin of
safety to the banking system as they provide a larger capital cushion to absorb losses, requiring
higher capital and leverage ratios are likely to have secondary-order consequences, ranging from
higher borrowing costs for end users of credit, to reduced rates of return on equity for banks and,
in the extreme, to a reduction in investor appetite as suppliers of that equity.31 The newly
imposed rules requiring increased minimal leverage capital requirements will have drastic
secondary effects and will fail to effectively prevent a bank from slipping into financial despair.
First, the new rules fail to address the riskiness of the assets, and thus, promote banks to
invest in the most risky assets in order to obtain returns consistent with last year’s earnings.
Second, the new rule will put domestic banks at a large disadvantage competitively to foreign
banks. Third, the new rule prohibits banks from being able to expand naturally. Fourth, the new
rule destroys the shareholder’s return on investment and decreases the banks appeal to investors.
Fifth, the new rule drastically curtails lending. Sixth, the new rule fails to account for off-balance
sheet assets.

14. Criticisms of the Newly Imposed Regulations
1. Leverage Ratios do not Differentiate Between Risky and Non-risky Assets.
If the leverage ratio were to be the primary form of capital regulation, it would create a
system that incentivizes the accumulation of riskier assets without requiring more capital against
those risky undertakings, which would in effect counteract the purpose behind the installation of
the leverage ratio requirement. If the leverage ratio becomes the main regulation for bank
capital, the comparison of banks to each other would be meaningless since banks could have
similar leverage ratios yet completely different risk profiles. Because it does not take risk factor
into account, the leverage ratio would not suffice as a capital regulation.
Leverage ratios do not differentiate between liquid, non-risky assets, such as cash, and
high-risk, illiquid instruments such as complex securitization products. By definition leverage
ratios cannot take into account the riskiness of the asset base. For leverage purposes, an asset is
an asset. Leverage on a balance sheet increases risk, but not all risks are equal. The riskiness of
leverage is directly related to the riskiness of the asset.32 Because the leverage ratio disregards
the risk profile of an asset, banks should not take into account for what or to whom they are
lending when calculating their total assets. Therefore, “a bank must reflect the same amount of
capital against a one week US Treasury bill as it does for a ten-year loan to a politically unstable,
fiscally challenged, emerging market country or a loan to a business with a bad credit history.”33
This process is counterintuitive to regulation efforts as it limits the use of risk-reducing
measures. Not all assets have the same risk factor, but the leverage ratio treats each asset as if
they do. Because of this, the correlation of potential loss to available loss absorbency is lost.

15. Though the imposed leverage ratio would attempt to limit the amount of leverage that a
firm can take on, companies can easily skirt those rules by purchasing riskier assets with the
leverage that they do have. These actions are comparable to “someone responding to gastric
bypass surgery by only eating butter and chocolate truffles.”34 In order to keep profits high,
firms will be forced to invest in riskier assets, which provide a greater return. Again, this would
juxtapose the intent of the leverage ratio as a capital regulation since companies would simply
invest in riskier assets without a consequential increase in capital to compensate for the added
risk.
What’s more, bankers, prompted by the need to comply with the leverage ratio rules, may
become complacent about liquidity buffers.35 The need to earn a profit while maintaining the
leverage ratio mandated by the new regulation could cause bankers to lose sight of the
importance of maintaining liquidity in case of a downturn. Raising capital is a costly and timely
process, and since the new regulation does not require additional capital based on risk of an
asset, bankers will strive to meet the capital amounts as required by the regulation but have no
motivation to exceed that amount. If these processes were to become commonplace in the
banking realm, the results would be catastrophic.
Because the leverage ratio calculation is not based on risk-weighted value of assets, but
rather the book value, this measure cannot be used to draw comparisons between two firms or
banks. Two banks reporting identical leverage ratios, even operating in the same markets, give
investors and analysts no indication of their relative capitalization given their risk profiles. One
bank could be providing home loans to highly rated borrowers with low loan-to-valuation ratios
while the other could be lending in the subprime sector with high loan-to-valuation ratios. Both
banks could have the same sized balance sheet and hence under the leverage ratio would report

16. the same levels of capital.36 If the leverage ratio were the primary measure of bank’s solvency,
then, despite obvious risk differences between the banks in the aforementioned example, there
would be no indication of the relative riskiness of their operations. The leverage ratio does not
provide a metric for assessing the risk of a business, nor comparing the riskiness of business
models.
Though at the heart of the regulation is the idea that banks will naturally take this risk
into consideration when deciding how to use their capital and determining the return necessary to
achieve maximum profits, the regulations here fail to address the concern of banks investing in
high risk ventures at the markets cost.
2. Higher Leverage Requirements put Domestic Banks at a Disadvantage to Foreign
Banks
European banks regulated by Basel III face a much lower leverage requirement than the
5% - 6% that is being proposed in the United States. Under Basel III, banks are only required to
hold capital equal to 3 percent of total assets, and thus are required to hold 2 percent less capital
in comparison to the eight largest financial institutions in the United States. By increasing
leverage requirements here in the US, the appeal of borrowing capital overseas will drastically
rise, effectively stunting our economic recovery.37 If a big eight bank is forced to comply with
higher leverage ratios, they will need to increase their interest rates in order to compensate.
Companies unable to either (1) obtaining funding because of a high risk investment or (2) unable
to afford the interest rate requirement driven by the new ratios, will simply contact Barclays in
the United Kingdom to obtain financing at a lower rate. This increased ratio will completely pull
the big eight banks out of competition, severely damaging their global standing and negatively
affecting their shareholders.

17. A proponent of the bill argues to this that megabanks in Switzerland, with even higher
capital ratios than those proposed in the United States, have no problem maintaining their
domestic clients, and still manage to generate large quantities of business. This argument,
however, will not hold up in the case of the United States. The appeal of the Swiss market is not
comparable to the domestic market here in the United States for the Swiss market is so miniscule
in comparison and does not seek to compete globally.
JP Morgan’s CEO, Jamie Dimon, showed his concerns relating to global competition if
the bill goes into effect and increases the bank’s required capital. Dimon, who was originally
supportive of regulations increasing the minimum capital ratios states that this proposed bill is
over burdensome to the biggest banks.38 Dimon added that “other details hit investment banking
activity core to U.S. banks hardest because of the threat that Asian banks, in particular, could
take U.S. market share due to the combination of U.S. domestic and global rules.”39 Clearly
there is a concern for remaining competitive on a global scale if the proposed regulations go into
effect. It’s been argued that there is a need for more regulation on the American investment
banking system; however sight cannot be lost on the big picture. It must be made certain that
changes made domestically do not hinder growth internationally.
3. The New Rule Restricts the Bank’s Ability to Expand.
Requiring higher levels of capital against debt held will greatly restrict the ability of
banks to invest in new opportunities by drastically limiting their mode of expansion.
Traditionally, banks expand as they see opportunities and market windows. Due to the
competitive nature of the financial world, little time is allotted to seize these opportunities and
action must be taken immediately in order to take advantage when opportunities arise. Typically,

18. banks can execute expansion rather rapidly by expanding their balance sheet and increasing their
debt financing when they see a viable opportunity.40 A higher leverage ratio requirement would
restrict this process and inhibit banks’ ability to advance on viable prospects in a timely manner.
Under this new regulation, banks would be unable to expand their balance sheet by financing the
additional debt needed to seize new opportunities as they arise and are instead forced to wait, and
potentially lose out on the opportunity at hand, while they accumulate capital for financing. This
change in procedure will make banks less nimble and unable to productively react to
opportunities in a quick paced and ever changing industry.
It has been argued that the new leverage regulation would seek to monitor this type of
expansion to prevent banks from being spread too thin too quickly; however, since this new
regulation does not does not take into account the asset risk profile of each bank in question, it
cannot successfully be applied to all banks universally. By setting a ceiling for the banks’
leverage on the basis of the size of the respective bank’s capital and its assets, regardless of their
riskiness, it limits the extent to which banks can expand their balance sheets, even for banks
whose operations are considered relatively risk-fee.41 Therefore this regulation would suppress
the growth of even the most stable of institutions and stagnate the growth of the market as a
whole. Use of the leverage ratio for capital regulation would tie the hands of the bank until its
balance sheets reflect the capital needed to balance the added debt for funding the project, even
for low risk and fiscally sound investments. Time is money, and time spent waiting to balance
out the leverage ratio would be costly for any firm. It is irrational to impose this type of
restrictions on bank expansion, especially if risk is not a contributing factor to the regulation.
4. The New Rule Injures Shareholders by Decreasing the Return on Equity.

19. Naturally, by imposing ample regulation on leverage limits, banks will be forced to raise
additional capital in order to comply with the capital requirements. Higher capital standards will
significantly restrict lending that, based on the new leverage ratio requirements, does not
generate an adequate return on investment.
Raising capital is a very expensive operation. It requires banks to halt issuing dividends,
increase their retained earnings, and issue additional shares of stock. By withholding dividends,
the bank will be able to retain additional capital, however, the longtime shareholders will be hurt
by the failed distribution. Additionally, because of the higher capital requirement, banks will be
forced to issue more shares thus diluting the value of the shares currently outstanding. This
directly injures the shareholders while providing little additional support for the banks fiscal
stability.
Additionally, different tiers of capital demand different levels of return, because they
expose the investor to different levels of risk; i.e. the riskier the investment, the greater the
return. If banks were forced to hold more equity, as the new leverage ratio regulation requires,
that equity would essentially become less risky, consequently creating a lower return to investors
of the bank. In order to appeal to investors, banks need to generate returns that are competitive
with other uses for investor capital.42 Higher capital requirements will make it harder to
generate those returns and thus hinder the ability for banks to attract investors. With the
installment of a leverage ratio, the average credit spreads will go up because banks need to get a
higher return on their lending to maintain the same return on a larger equity base, and for some
borrowers the higher credit spreads will make their businesses no longer profitable.
Supporters of the new regulations argue that banks should not issue dividends but rather
reinvest earnings back into the banks’ expansion. This argument stems on the idea that a

20. company’s retained earnings increase the shareholder’s value and thus, shareholders should be
satisfied that their investment is gaining a return identical to that of the banks’ return on assets.
However, with the increased minimum capital holding requirements, the bank is guaranteed to
receive a lower return on its assets since it will no longer be able to invest into as broad of a
market. Since this will decrease the overall return on assets, reinvesting earnings back into the
bank will decrease shareholder earnings, which shows that withholding dividends, in this
instance, is inconsistent with the best interests of the shareholders.
In the end, withholding dividends and diluting existing shareholders in an attempt to raise
capital has a negative effect on shareholders and tends to drive share prices down, thus
counteracting the bank’s capital-raising endeavors.
Proponents of the increased leverage ratio also argue that the capital requirements do not
hinder shareholders, but instead provide them with more confidence that their investment is safe
because of the lower risk associated with the increased capital requirements. This statement is
only true in part. Though a higher capital requirement will lower the risk of insolvency, the
higher capital requirement will not lower the risk of seizure by the regulators. If for some reason
a bank is unable to meet their leverage minimums, the bank will be swept into regulatory control
and the regulators will have complete control over the bank’s operations, may close the bank
entirely, or close the bank for a given portion of time.43 This is will indefinitely result in lower
stock prices, if not destroy the value of the stock all together.
5. The New Rule Curtails Lending.
As it stands now, banks generate a majority of their income from the interest earned on
less than premium grade investments. Imposing this leverage regulation and forcing banks to

21. lend only to the safest of customers will drastically diminish applicants in the lending pool.
Many projects will be unable to get off the ground and will halt economic development and
innovation. Only established companies with successful track records will be able to easily
obtain funding. Other, riskier ventures will be forced to walk down the dangerous path of
seeking funding through venture capital, private equity, and other management assisted capital
growth methods. These methods are commonly known in the business world for being less stable
than traditional banks, further increasing the odds against the success of start-ups.
Further elaborating on the banks inability to lend to small businesses, though there is a
fine line between what is and is not a prime investment, the new capital requirements will move
the line too far toward rendering the investment as too risky. With the new leverage maximums,
banks that currently lend to risky businesses will be unable to make such loans because the
adjusted returns will be too low to justify the capital required to make them.44 Not all risky
investments are bound to fail and by cutting out the ability for banks to lend only to safe
operations, the banking industry will change dramatically.
An argument can be made that a higher leverage requirement, and thus a higher capital
account, actually promotes banks to increase lending. Though “voluntarily high levels of capital
can indeed encourage lending during a credit crunch, regulatory capital requirements have the
opposite effect” according to an advocate for decreased regulation.45 Due to the fear that
regulatory authorities will seize all banking operations during a credit crunch, the bank in this
situation will have more trouble financing loans during the threatening period. This threat allows
creditors to be fearful of seizure, and thus will be extremely hesitant to issue loans. At the end of
the day, a bank merely needs to retain the ability to have enough capital to stay solvent and
above the regulatory minimum.46

22. However, in the instance of a bank seizure, the regulating authority seizing the bank will
be forced to pay off creditors with the remaining bank assets. This argument could be construed
to reduce the loss from a bank defaulting on its obligations
6. The New Rule Fails to Include off-Balance Sheet Exposures.
After the crisis, many commentators blamed the exclusion of off-balance sheet exposures
as a major roadblock to the regulators’ ability to monitor the leverage of big banks. Despite these
concerns, the proposed rules fail to take into account the oversight of Special Purpose Entities
and other off-balance sheet assets.47 A Special Purpose Entity, for example, is considered an off-balance
sheet entity because its assets and liabilities are legally separate from the bank and are
not required to be consolidated into the balance sheet of the bank that formed the entity. These
vehicles open the door for banks to manipulate leverage ratios by buying and selling assets
between entities by their own discretion in order to avoid breaching leverage minimums.
In can be argued that by excluding off-balance sheet exposures from the proposed rule,
that the regulators are almost forcing the banks to trend back to their pre-crisis methods of book
keeping, which is most certainly in contradiction of the initiative behind the new regulations.
VI. RECOMMENDATIONS
With the aforementioned criticisms in mind, I believe that a complete overhaul of the
new rule proposals is in order. First, I believe that the market is better fit to regulate bank
leverage than a third party regulator, and thus, the former 3% leverage minimum is fitting.
Secondly, I recommend that the big banks provide transparency to shareholders by disclosing
their current leverage ratio and the riskiness of the assets involved.

23. The Market is able to Decide if a Bank is Adequately Financed
The market is able to check the financial stability of the institution in two forms outlined
below. In the first form, other financial institutions that typically lend to one another are in a
position to check the financial stability of other firms. In a second sense, the shareholders of a
corporation, through adequate disclosure, are able to assure their company is financially
adequate.
i. Market Checks by Lending Institutions
A static restriction on a dynamic market seems counterintuitive and could cause more
harm than good. The market should be able to decide whether banks are properly leveraged.
Because banks rely entirely on short term lending, the market should decide the fate of these
large banks by simply looking at the balance sheets and determining whether or not a bank is
credit worthy. With a high a leverage ratio, the suspect bank will be unable to obtain financing
due to its risky debt position and thus be unable to fulfill its short-term obligations.
As aforementioned, banks make their income by providing short term funding to
companies and other organizations seeking capital. If a bank is unable to prove its
creditworthiness in order to obtain funding for itself, it will then be unable to provide loans to
customers. If its leverage position restricts the bank from performing the core functions of its
business, an overleveraged bank will be forced to diminish its ratios in order to continue
operations. According to Gary Gorton, lenders in the commercial paper market and other short-term
money markets, like depositors in a bank, place the highest value on safety and liquidity.48
Through this process, the market essentially regulates itself without the need for overcomplicated
and unnecessary oversight.

24. Additionally, a set leverage ratio is not consistent with constant changes of the market.
Leverage tends to be procyclical by rising in good times, when the confidence of lenders and
borrowers is high, and falling in bad times, when confidence turns to caution.49 By allowing the
market to judge the stability of loans on a bank’s books, the market is able to decide whether or
not the transaction is too risky.
Banks are more familiar with the current lending structures and stability of the market.
Lending structures and ratios are constantly changing. Simply put, the regulators are unable to
adapt quickly enough to keep up with fast paced trends and fully comprehend changes in
practices. Large banking institutions, on the other hand, employ hundreds of people to closely
monitor trends in the market and analyze the risks of the new methods as they develop.
Elaborating on this argument, the eight biggest banks threatened by the proposed rule are
and have much stronger teams of financial analysts, economists, and risk managers than any
branch of the United States government and are much better equipped to monitor changes in the
market. These banks recruit the top students in the top business schools from around the world.
The vast majority of these phenomenal individuals pursue careers with the Big Eight rather than
a career with a regulatory group since the big banks are able to pay top dollar for such skills.
Because of this, these institutions have the best resources available for determining the riskiness
of a loan and the stability of a bank in comparison to federal regulatory oversight.
ii. Market Check by Shareholders
Aside from banks regulating one another, I further recommend that the shareholders of
these big banks thoroughly assess and monitor their investments by requiring these big banks to
disclose their leverage ratios in a simple and straightforward document dedicated solely to the
disclosure of this information. This way, the leverage ratio will not be lost or hidden in the

25. multitudes of reports and analysis provided to shareholders. By requiring leverage ratio
disclosures in this form, investors, both passive and active, will be better able to assess their risk
standings as well as make informed business decisions. Because shareholders stand behind
creditors in the instance of bankruptcy or insolvency, shareholders will protect their interest in
promoting the solvency and liquidity of the company, which begins with a thorough
understanding of the company’s leverage position.
As it stands now, these big banks are public companies and, as such, are required to
disclose their potential risks in the MD&A section of their 10-K. This disclosure, despite the
importance placed on it by federal regulators, is typically buried deep inside a 10-K. For
example, in Goldman Sachs most recent 10K, they briefly described their leverage ratio on page
113 of their 10-K. Again, I recommend that in addition to disclosing, or hiding, the leverage ratio
within the 10-K, regulators need to require the big banks to issue a simple and concise document
to shareholders describing the leverage ratio and the riskiness of the assets relating to it.
These large financial institutions are some of the most closely followed stocks in the
world. Like with any other company, if a financial analyst finds the bank has too high a leverage
ratio, the shareholders will use their power to make the changes necessary to bring it back down.
Providing further support, many institutional investors hold large amounts of stock in a
company and have great influence over the decisions of the board. If a large fund sees a risky
leverage ratio, the fund could easily dump the stock or go directly to the board to seek change.
Due to the compensation structures of boards of directors and officers of these corporations, the
likelihood of the bank responding to the institutional investors is extremely high.

26. The Fear that Market Checks do not work until it is too late
Many critics of reducing government regulation on leverage claim that the market check
system does not work until it is too late. One critic of the idea proposed the example of the
market’s check on Lehman Brothers. The market continued to lend to Lehman until several days
before Lehman was forced into bankruptcy. By the time the market realized that Lehman’s
balance sheets were unworthy of lending, the bank was in too deep of debt as it was leveraged
near 40:1.
This argument fails because changing leverage ratio requirements will not prevent this
event from occurring. As stated, Lehman Brothers had an extremely high leverage ratio, which
was merely a side effect of its overinvestment in risky loans. According to the report issued by
Anton Valukas, the bankruptcy examiner for Lehman Brothers, leverage was not the culprit here
but rather “the main reason for Lehman Brothers’ downfall was its imprudent lack of
liquidity.”50 Again, because leverage ratios do not make a distinction between liquid, non-risky
assets and high-risk, illiquid instruments such as complex securitization products, like the assets
held by Lehman at the time of its collapse, it does not make for a sufficient metric for monitoring
the activities of big banks.
By requiring the banks to disclose their leverage ratio and a detailed description of the
assets linked to the ratio, several events would have occurred that direct regulatory oversight
would not cover. First, if, as I recommend, Lehman was forced to disclose to shareholders a
simple explanation of the leverage ratio and the extremely risky assets it had invested in,
financial analyst would have flocked to the news to report the risk long before Lehman was over
leveraged. Furthermore, financial institutions that lent to Lehman would have been quite aware

27. of their condition and would recommend Lehman decrease their leverage ratio in order to
comply with their own internal risk management measures.
Additionally, many banks continued to lend to Lehman with confidence that a
government bailout would protect their investment in times of default. Bailouts are no longer an
option, which should be a tremendous wake up call to investors. This knowledge should prompt
investors to evaluate the risk of their investments and make a complete and prudent conclusion
before taking action.
VII. CONCLUSION
The financial crisis demonstrated that the U.S. leverage ratios did not prevent the collapse
of 140 banks in 2009 and 157 in 2010. A higher leverage ratio is not the answer. Though it will
provide the bank additional cushion in the instance of a major decrease in assets, we need to be
more concerned with avoiding the decrease in assets and promote investors and lenders to be
aware of risky investments. I am not recommending we abolish all minimums and let the banks
run free to do what they will, I simply find that the new rule places a much greater burden than it
accomplishes in providing a larger cushion in the event of a crash.

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2
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27
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30
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