Leverage

| Mon Dec. 1, 2008 6:07 PM EST

LEVERAGE....Matt Yglesias approvingly notes something that Hank Paulson said today:

We need to get to the place in this country where no institution is too big or too interconnected to fail.

Hmmm. Is this even possible? Trying to regulate leverage is hard enough, but trying to directly regulate size and "interconnectedness"? Do we really want to do that?

Take AIG, for example. Was the problem that AIG was too big? Not really. The vast bulk of its business, after all, was in ordinary state-regulated insurance lines that weren't causing any problems. Their famous CDS losses were concentrated exclusively in the AIG Financial Products division in London, which employed a grand total of 377 people. The problem wasn't so much that AIG itself was too big, but that they allowed a small division to run amok.

(It's true that there's an indirect sense in which AIG's size allowed them to get into so much trouble: namely that CDS buyers trusted AIG's AAA rating so much that they didn't require them to post collateral. But that's pretty indirect.)

Beyond that, there's another problem: the world needs big banks. Large multinational corporations just aren't going to do their banking at a small community credit union, after all. They want to deal with a big money center bank that has plenty of lending capacity, expertise in a wide variety of areas, and branches around the world. You just won't find that in a small bank.

And then there's the interconnectedness problem. Bear Stearns wasn't really all that big (a fraction the size of Citibank, for example), but the Fed rescued them because they were afraid of cascading counterparty risk if they failed. Later they let Lehman Brothers fail, and they discovered that their fears were well founded. But how do you regulate that?

The modern world is a big place, and there's no way to turn back the clock. Big corporations and big banks are here to stay, whether we like it or not. Frankly, Paulson sounds to me like he's trying to mouth some feel-good words that he knows will never be taken seriously but make him look like he's getting tough on Wall Street. I'm not buying it. For my money, I keep coming back to the same thing: leverage, leverage, leverage. The key is to regulate leverage to reasonable levels and to regulate it everywhere. If it walks like a bank and quacks like a bank, then it's a bank and its leverage ratios should be regulated. That's what will keep banks from being too big to fail in the future, and this time around we shouldn't allow Congress or the SEC to toss off a few bland platitudes and then do nothing serious about it. Leverage is where the action is.

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