Observers of small children and researchers of drunk driving know that rules are only effective if they can curb bad behaviors and encourage good ones. New rules requiring higher levels of bank capital are intended to help prevent widespread financial system meltdowns -- but what if they end up doing more harm than good? 

A simple rule that's supposed to be better -- but might not be
The problem with the old capital requirements is that they're based on what are called risk-weighted models, meaning the rule is based on estimates about how risky an individual asset might be. 

Unfortunately, between human error and a very powerful incentive to underestimate risk levels, these models are inconsistent and may be prone to manipulation.

To make up for these issues, regulators have implemented a simple leverage ratio requirement on top of the old rules. In Europe, banks have to have 3% of their total assets in safe, accessible capital. In the U.S., the 3% rule applies to smaller banks, while for large banks, the requirement is 5%.

That sounds like a good start, although the new rule has been criticized for setting too low a bar considering the risks that banks -- particularly large ones -- like to take.

But now, two researchers for the European Central Bank suggest that the requirement might even be counterproductive: Instead of reducing risks, the leverage ratio might raise them.

How it works: A basic picture of banking
Imagine for a moment that there are two kinds of banks: low-risk banks, which make traditionally boring bank loans, and high-risk banks, which have higher-risk lending portfolios and maybe even some funky assets on their balance sheets (or off them, as the case may be). 

Banks tend to specialize to some degree in the real world, so while this is an oversimplified picture, it's not all that far off of the reality. 

In this environment, if something goes sour for a particular kind of loan (cough cough, subprime), chances are, not all banks will be holding it. A given crisis could thus affect a few (or even many) banks, but it won't affect every bank. 

Specialization, in other words, provides a bit of a buffer against completely unmitigated contagion.

Capital requirements and shifting loan portfolios 
Now, imagine that all banks have to meet the new double-barreled rule: a risk-weighted capital requirement, which is based on how risky that particular bank's assets are, and a straight leverage ratio requirement, which is based on total assets and calculated in the same way for all banks. 

If you're a risky bank, you'll probably need to dial things down a little to get in line with the leverage ratio requirement. That might involve disposing of some risky loans, taking on new low-risk loans, and beefing up your cash reserves.

On the other hand, if you're a low-risk bank, you might find yourself in a tricky situation. Under risk-weighted requirements, you don't need all that much capital, but under the leverage ratio, you need more. Having to keep more capital on hand means the cost of funding your low-risk (i.e., low-revenue) loans goes up. 

Thus, for a low-risk bank, this might be a good opportunity to diversify into higher-risk loans. They're more profitable, so you can make up for your higher costs, and you won't be penalized for taking them on because you'll still be safely within all the capital requirements. 

So, assuming the leverage ratio requirement is rather low -- which it is in real life -- banks will just trade high-risk and low-risk loans among themselves until everyone satisfies the rule. 

Except that's actually a problem
The trouble is, what happens if something goes wrong in a particular type of loan? Under these circumstances, more banks may be holding onto it, which means bigger problems for more banks in the event of a crisis.

Consider the subprime crisis or the European sovereign debt crisis. Everyone thought securitized home loans and Greek sovereign bonds were totally safe -- until they weren't. And when everyone is holding onto loans that aren't safe, you have a much higher risk of contagion, meaning the toxic consequences of a crisis can spread to more banks.

So, what would help?
The key issue, according to the math in this study, anyway, is that the leverage ratio should be higher. Right now, it's only high enough to stimulate diversification; it's not high enough to prevent contagion in the event of a major shock. 

The ECB study authors calculate that the leverage ratio requirement should be about the same as the average risk-weighted capital requirement. For large banks in the U.S., this would translate to something like 8% to 10%.

Whatever the solution is, the short-term issue is a worrying one: We might be thinking leverage ratios are making our banks safer, while they could just be adding new risks to an increasingly interconnected industry. 

I'm not too eager to learn how this might play out in another financial crisis. 

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