Capital reserves are the key to financial reform

This is an important editorial from the NYT.

As financial sector lobbyists work to gut the financial regulation bill that Congress passed last year (Dodd-Frank)—and the Rs seek to repeal it—it’s somewhere between mind-numbing and soporific to follow the details. There’s the Volcker rule (which restricts banks from proprietary trades—betting their own “book”), the Consumer Protection Bureau, derivatives regulations, and…

Capital reserves.

There are many malfunctions that contributed to the financial market meltdown in 2008, from liar loans, lousy underwriting, feckless credit raters, originate-to-securitize and distribute, to blind allegiance to Greenspanian self-correction hypotheses. They all need to be addressed.

But if you forced me to choose one thing to change in perpetuity, it would be the rules governing capital reserves—the amount of capital banks and nonbanks (these rules should apply to institutions that speculate in markets, regardless of what it says above their doorways) must keep in reserve as a cushion against losses.

You can get a lot of the other stuff wrong, but with a strong capital requirement rule, you’ve built in a backstop against overleveraging. In fact, after the crash, the extent to which banks were unsustainably leveraged was often discussed in terms of leverage ratios that were 40 and 50 to 1, instead of 10-1.

The banks and hedge funds and PE shops will fight tooth and nail on this one: a dollar sitting around creating a cushion can neither be used to buy Dutch tulip bulbs nor subprime MBSs.

To which we should all say: tough toenails. You want to drive the global financial superhighway, be my guest. But put on your seatbelt before you hurt yourself and everybody else…again. And that means ample capital reserves.