Jamie Dimon
Jamie Dimon; drawing by Pancho

Why, Federal Reserve Chairman Ben Bernanke asked rhetorically in an April 2012 speech, did the collapse of the trillion-dollar market for subprime mortgages set off the most severe financial and economic crisis since the Great Depression? Twelve years earlier, in 2000, the crash of high-flying technology companies such as Cisco Systems and dot-com companies such as Amazon and the now defunct Pets.com wiped out roughly $6 trillion in assets, but it set off only the relatively short and mild recession of 2001. Cisco and especially Amazon are today much larger.

The answer, now widely accepted but clearly not appreciated sufficiently at the time, is that the 2008 crisis was made possible by an extremely fragile financial system in which banks and many other businesses indulged in excessive leverage—too much borrowing—as well as hazardous reliance on short-term funding and negligent risk management, with lax regulatory supervision by the government.1

That there is wide agreement on the causes of the crisis should not be surprising. It is hardly novel to recognize, for example, that short-term borrowing can be quite precarious during a crisis when lenders become cautious and loans that come due cannot be renewed. This forces the borrowers to sell assets, further depressing asset prices and deepening the collapse, a chain reaction that propels severe crises.

The basic problem, however, was not ignorance of such dangers, but that federal and state regulators in the mid-2000s were not sufficiently vigilant in anticipating and controlling them.2 Awareness of these failures has still not been translated into adequate legislation and new regulations. The banks were allowed to run wild by those charged with regulating them—particularly in borrowing imprudently and in acquiring and creating soon-to-be-worthless mortgage-related securities. The Federal Reserve, led by Alan Greenspan and Bernanke, should have been questioning and restraining these practices. It did not do so, and too little has been done to make another crisis much less likely to happen.

The regulatory failures in the buildup to the recent crisis were induced by the same complacency that infected the financial system and economy in the latter stages of the period economists call “the great moderation,” beginning in the early 1980s and spanning roughly two decades of relatively steady growth and low inflation, interrupted only by recessions that were short and mild.3

Similarly, the tepid recovery from the 2007–2009 “great recession,” although very modest compared to others, has allowed politicians and regulators to yield to intense lobbying and legal challenges launched by the financial industry to chip away at proposed reforms. Particularly unfortunate are the failings of the Dodd-Frank legislation. Too complex and yet too vague, it offers countless opportunities for lobbyists to weaken or exploit its provisions. Lobbying pressures were evident in the prolonged negotiations among the five regulators responsible for writing the Volcker Rule, which prohibits banks from trading for their own accounts. (The regulators consist of the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC), the Comptroller of the Currency, the Commodity Futures Trading Commission (CFTC), and the Securities and Exchange Commission (SEC).) They finally agreed on a rule on December 10, 2013—and it still contains many loopholes that banks such as Goldman Sachs and Citibank can easily use.4

The Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law by President Obama on July 21, 2010. Three and a half years later only about half of its provisions have been converted into functioning regulations. The act is more than eight hundred pages long and still often fails to be specific. It gives responsibility for designing specific regulations of derivatives to the CFTC, and it assigns the Fed to regulate the largest banks and nonbank financial companies. Dodd-Frank also created the Financial Stability Oversight Council, an interagency group that is chaired by the Treasury secretary and is charged with “coordinating” the views and actions of the main financial regulators with regard to the emerging risks to the system.

Will institutionalizing “coordination” improve matters? The agencies’ assessments of possible danger to the economy in the mid-2000s were extremely ineffectual. They saw few risks. Now many people with different political views, including current and former high-ranking officials of the Federal Reserve such as ex-Chairman Paul Volcker and Richard Fisher, president of the Federal Reserve Bank of Dallas, are deeply frustrated by the sheer wastefulness and ineffectiveness of the Dodd-Frank process.5

The most pressing task of reform must be to strongly limit the risks posed to the economy by large banks and other financial institutions that borrow so much. The best way to achieve this goal is to explicitly limit the extent to which they borrow to fund their operations. Rather than interfere with how banks operate, as does the Volcker Rule or proposals to break up large banks, such requirements restrict only the way banks finance themselves.

In their recent book, Anat Admati and Martin Hellwig convincingly make the case for much stronger and simpler borrowing limitations for banks. “Whatever else we do,” they write at the beginning of The Bankers’ New Clothes, “imposing significant restrictions on banks’ borrowing is a simple and highly cost-effective way to reduce risks to the economy without imposing any significant cost on society.” But they warn that the issue poses “a fundamental conflict between what is good for bankers privately and what is good for the broader economy.”6


Admati, a professor at Stanford Business School, has been a leader in public debates on how best to regulate banks since at least 2010, when she brought together nineteen other finance professors, including Martin Hellwig, head of the Max Planck Institute in Bonn, and Nobel Laureate William Sharpe, to produce a famous letter, entitled “Healthy Banking System Is the Goal, Not Profitable Banks,” which appeared in the Financial Times that November and is elaborated in the book.7

Borrowing restrictions for banks are very much like the down payments banks require of home owners applying for a mortgage, a comparison used by Admati and Hellwig to illustrate how leverage amplifies both gains and losses and to familiarize readers with balance sheets. Consider, for instance, a home owner who purchases a $300,000 house, putting up $60,000 of her money and taking out a $240,000 mortgage. As shown in Figure 1 (see below), the buyer has levered her equity five to one, investing 20 percent of the purchase price (her equity) and borrowing the remainder. Until repaid, the amount borrowed remains fixed, while the equity varies with the value of the house.

This means that if the home’s value rises (or falls) by 10 percent, her equity will be 50 percent higher (or lower)—if the house is now worth $330,000, after subtracting the $240,000 mortgage she now has $90,000 in equity. More important, only if the value of the house was to depreciate by 20 percent or more would the owner’s investment be wiped out. This example contrasts sharply with practices during the frenzied housing market of the mid-2000s when down payments were far lower, resulting in leverage of as much as twenty to one, or even infinite (when no down payments were required), sometimes for borrowers with undocumented incomes (so-called “liars’ loans”).

Called capital requirements, limits on banks’ borrowing are generally expressed as a ratio of a bank’s equity to its assets. Like any corporation, a bank is owned by its shareholders, and its equity—really its shareholders’ equity—consists of funds they invested in the bank’s own share offerings and earnings that have been retained in the business rather than paid out in dividends or in buying back the bank’s shares.

If the bank were liquidated, each shareholder would be entitled to a pro rata share of that equity. But the real value of the bank’s shares derives from their claims on the bank’s future earnings and dividends. This value becomes clearer when the shares are traded, which shifts ownership but does not affect the bank’s equity.


The simplified version of JPMorgan Chase’s year-end 2011 balance sheet in Figure 2 shows these relationships for our largest bank. The left-hand column—the asset side of the balance sheet—shows that the bank had assets of $2.27 trillion in the form of cash ($145 billion), loans it had extended to its customers ($696 billion), and trading and other assets it had acquired ($1.43 trillion). Similarly, the right-hand side of the ledger shows liabilities—the bank’s obligations to others—of $2.09 trillion. These consist of deposits ($1.13 trillion)—in effect borrowings by the bank, some of which must be paid back on demand—and other loans they received, some short-term ($698 billion) and the rest long-term ($257 billion). That banks operate as both borrowers and lenders is essential to some of their primary functions, transforming short-term borrowing such as deposits into longer-term, and riskier, loans and investments.

The difference between assets and liabilities is its shareholders’ equity, also known simply as a company’s “equity” or “net worth”: what the bank’s shareholders own (as opposed to all the assets that the bank owns, or the liabilities it owes). At the end of 2011, Morgan’s net worth was $184 billion, roughly 8 percent of its assets. This is far better than had been the case before the crisis but still substantially less than the finance professors or Admati and Hellwig think is necessary. The finance professors believe that ratio should be at least 15 percent. Admati and Hellwig recommend a minimum of 20 percent.

As for home owners, equity is critical to banks’ safety. Unlike funds borrowed from depositors or other lenders, equity never has to be paid back and thus provides an essential buffer against potential losses. If a bank’s equity is 20 percent of its assets, it can absorb losses of 20 percent of those assets before it becomes insolvent, that is, before its liabilities exceed its assets. But if the ratio is 5 percent or less, as was the case for many large banks as the crisis erupted, the bank is vulnerable to relatively small losses. As a result, many of the banks had to be bailed out or shored up with taxpayer funds.


The Troubled Asset Relief Program (TARP), which was signed into law in October 2008, paid out $245 billion to US and foreign banks, including $45 billion each to Bank of America and Citibank. In addition, troubled firms such as Bear Stearns were absorbed by stronger companies (JPMorgan) with government assistance or, in rare cases such as Lehman Brothers, allowed to fail.

Stricter capital requirements are even more important now in light of the growth of the largest banks since the crisis. That growth continues a long-term trend that had accelerated markedly as the financial system was deregulated over the last several decades. During this time the banking sector grew enormously, both absolutely and relative to the economy. Between 1970 and 2010, for instance, the ratio of bank assets to GDP in a group of fourteen advanced economies grew from roughly 70 percent to over 200 percent—five times as fast as the pace in the hundred years before. That meant the banks’ assets in 2010 were more than twice as large as the value of all goods and services produced in these fourteen large economies.


Pete Souza/White House

Paul Volcker and President Obama in the Oval Office, January 2009

The proportion of bank assets controlled by America’s three largest financial institutions—JPMorgan Chase, the Bank of America, and Citibank—also surged, especially in the United States, where it rose from 10 percent of all bank assets in 1990 to 40 percent in 2007. Today some 47 percent of bank assets—including bonds they own, loans they’ve extended, and stocks and other securities they acquired—are held by the three largest banks. Concentration of bank assets in countries such as the UK, Switzerland, and Germany rose more slowly from a far higher level and still are much above those in the US.8

In calling for substantially higher capital requirements, both the finance professors and Admati and Hellwig stipulate that the assets be actual numbers—not figures that have been massaged and adjusted, as is often the case, in order to reflect the assets’ supposed riskiness. When calculating a bank’s capital ratios, regulators assign percentages ranging from zero to 150 percent to the assets, with zero representing assets that are thought to be as safe as cash. These adjustments do not affect the equity itself but can have a material impact on the ratio of equity to assets.

In other words, if a bank’s total assets are $100 billion and 30 percent of those assets, such as US Treasury bonds and even Greek government bonds before the crisis, are given a zero risk weight and the rest a weight of 100 percent, total risk-weighted assets are $70 billion, artificially inflating the bank’s ratio of equity to assets by 40 percent. This fantastical approach, a prime example of the “false precision” that has infected finance and economics, has shaped capital regulations since the early years of the century with predictably harmful consequences.

The idea of adjusting for the riskiness of bank assets in establishing capital requirements was developed and promoted by the Bank for International Settlements (BIS), an organization of central banks based in Basel, Switzerland, that tries to coordinate bank regulations. But these risk weights are far from well-established constants and can change dramatically as conditions change. Bonds issued by the governments of Greece and Spain, for example, were considered as safe as cash prior to the crisis under the “Basel system.” Thus they required no equity to back them up. Similarly, mortgage-backed derivative securities that were rated AAA by the rating agencies were considered only marginally more risky than Greek and Spanish government bonds. But those bonds and securities quickly turned to junk as the crisis intensified and it became clear that neither the Greek nor the Spanish government nor the pools of mortgages backing the securities could meet their obligations. As a consequence, many large financial institutions that were supposedly well capitalized under the Basel system either failed—as with Lehman Brothers—or, as was the case with AIG, were bailed out by regulators who feared their bankruptcy would further cripple the economy.9

In view of the Basel system’s fundamental problems and costly failures, it is remarkable that its basic approach has been adopted by the Fed and most other bank regulators as the basis for their reforms. Even now, under Basel III, supposedly an improved version of the BIS’s standards, huge discrepancies still exist between risk-weighted capital ratios and straightforward ones. Goldman Sachs recently estimated that the five most aggressive European banks had average equity capital of less than 3 percent of their assets. That is, they had borrowed roughly 33 billion euros for every billion euros of shareholders’ equity. However, the same banks had average ratios of capital to risk-weighted assets of about 8 percent, making them appear almost three times more securely capitalized than they were. Much the same is true in the United States, although banks’ capital ratios are higher, and their leverage lower, than in Europe. JPMorgan, Bank of America, and Citibank all have simple capital ratios above 5 percent.

Bankers, their lobbyists, and even some regulators claim that stricter constraints on bank borrowing, such as those proposed by Admati and Hellwig, would reduce lending and economic growth. A report by Davis Polk & Wardwell, a leading international law firm that represents many major financial institutions, claims that such constraints could even cause a credit crisis and another recession.10 Such assertions are highly exaggerated, unsubstantiated, and implausible. With tougher capital requirements, banks could continue to operate as before simply by funding their operations with more shareholders’ equity relative to the debt they take on. They could do so by retaining more of their earnings in the business or by selling new shares. And if instead they chose to shrink their operations, smaller competitors would be likely to pick up any slack.

Even if the claim that stiffer capital requirements would make credit less plentiful were more believable, however, any such harm to the economy must be weighed against the huge social costs of a major crisis. In addition to bailouts and other emergency aid, these costs include years—more than six, so far—of lost output and employment relative to what we might have seen had the crisis been averted. Some analysts think the costs of the financial crisis in the United States are more than $13 trillion, almost a full year’s GDP.11

Much like polluters who don’t bear the costs they impose on society, large, highly leveraged banks create significant risks to the financial system and the economy but don’t shoulder the bill for the resulting damage. Essentially banks and bankers benefit from a one-way bet. They profit from high leverage on the upside—high leverage amplifies banks’ profits, their share prices, and the bonuses of executives and traders—but leave disasters for taxpayers to clean up. It’s a sweet deal and explains why they are fighting so hard against serious constraints on leverage.

Dodd-Frank’s response to the bailout of banks “too big to fail” (TBTF) was highly publicized but largely hollow. It prohibited taxpayer-funded bailouts and restricted the Fed’s emergency lending powers. But commitments of this type, enacted when they are no longer necessary, are not likely to be binding in a future crisis when the costs and benefits will be very different from what they are today. Even though they favor limiting bailouts, Fed officials such as William Dudley, president of the Federal Reserve Bank of New York, have said that the Dodd-Frank pledge will be credible only if banks are made much safer through such measures as tougher capital requirements.12

Requiring banks to borrow less and boost shareholders’ equity would also counteract government subsidies that encourage them to borrow and take on more risk. These include the preferential tax treatment of corporate debt: interest on such debt is tax-deductible, but dividends to shareholders are not deductible. Other subsidies include the inadequate premiums banks pay to the FDIC for deposit insurance, which don’t cover the FDIC’s costs in distressed times.

But the most significant subsidies are implicit guarantees that governments will aid significant financial institutions rather than risk the consequences of their failures. These guarantees were made explicit—and thereby reinforced—during the crisis. In 2008 about $2.2 trillion in emergency aid was pumped into the financial system, $900 billion provided by the Treasury and $1.3 trillion by the Federal Reserve. Since then the Fed has been lending to banks at rock-bottom rates, enabling them to earn a relatively safe return on that money and build back their decimated balance sheets. One of the reasons Goldman Sachs and Morgan Stanley became banks in 2008 was to be eligible for some of this aid (they each received $10 billion in the first TARP disbursements to banks).13

Such implicit and explicit subsidies for banks that are thought to be too big and too important to be allowed to fail enable them to borrow more cheaply. Bank of England calculations reported by Andrew Haldane, its director for financial stability, show that these subsidies for the world’s twenty-nine most significant banks accounted for roughly half their profits from 2002 to 2007. Strikingly, further estimates suggest that capital requirements on the order of 15–20 percent would not only greatly reduce the likelihood of future crises but would limit their costs to much more manageable levels, tens of billions a year as opposed to trillions. Indeed, equity of 15 percent or more would have shielded our largest banks from insolvency during the recent crisis.14

During the last year or so we have seen a renewed push for stiffer capital requirements as well as for measures to break up the larger banks along the lines of the Depression-era Glass-Steagall legislation, which separated traditional banking activities—taking deposits and making loans—from trading and other investment-banking functions. Elizabeth Warren, together with John McCain and others, has spearheaded the latter approach while the progressive Ohio Senator Sherrod Brown and the conservative Senator David Vitter of Louisiana have revived debate about capital requirements. Their bill, introduced in the Senate last April, provides a clear and forceful alternative to the Fed’s dangerously weak proposals.

The bill would require regulators to “walk away from Basel 3, and institute new capital rules that don’t rely on risk weights and are simple, easy to understand, and easy to comply with.” As Brown and Vitter wrote in The New York Times, the goal is to “lower the likelihood that an institution will fail and lower the costs to the rest of the financial system and the economy if one does.”

The mechanism they propose is straight from Admati and Hellwig’s playbook. “Megabanks” with assets of more than $500 billion—JPMorgan Chase, Citigroup, Bank of America, Wells Fargo, Goldman Sachs, and Morgan Stanley—would be required to have shareholders’ equity equal to at least 15 percent of their assets, roughly double what they have now and more than four times what they had in 2007.15

The Brown-Vitter bill came about amid growing dissatisfaction with the complexity and weakness of the Fed’s Basel-based rules on bank capital, both within the Fed and in allied agencies such as the FDIC. Thomas Hoenig, FDIC vice-chairman and a former president of the Federal Reserve Bank of Kansas City, calls Basel III a “well-intentioned illusion.” Within the Fed, Charles Plosser, president of the Federal Reserve Bank of Philadelphia, is particularly close to the views of Admati and Hellwig and Senators Brown and Vitter in calling for an approach “that relies on simple but higher leverage ratios [capital ratios]…[that] rise with the size and complexity of the institution.”16

Partly owing to such pressure, our bank regulators—the Treasury’s Comptroller of the Currency, the Fed, and the FDIC—proposed in early July that the Basel system’s attempt at a simple capital ratio (they call it a “leverage ratio”), which applies to banks with assets of at least $700 billion, be increased to 6 percent from 3 percent.

Of course, 3 percent was ludicrously weak, comparable to levels that were common in 2007, which made the financial system so vulnerable and the crisis so severe. The rule was finally approved on April 8, 2014, and will take effect on January 1, 2018. To comply, banks are likely to need $68 billion in additional equity.17 Even if 6 percent still is far too low—the FDIC’s Hoenig thinks it should be at least 10 percent while Admati and Hellwig and Senators Brown and Vitter want higher still—it pushes the simple capital ratio close to a point where it would act as a constraint on banks’ borrowing, superseding Basel’s risk-weighted capital ratios. The regulators also proposed including more derivatives among bank assets, an adjustment thought to account for two thirds of the additional capital.

More importantly, it comes at a time when momentum for reform is building while fissures are developing between some of the regulators, especially the FDIC, whose more aggressive demands for effective new rules stand in sharp contrast to the Fed’s tendency to yield to pressure from its large-bank constituents. Recent reports by the IMF and Federal Reserve Bank of New York have contributed to that momentum. The IMF devotes a chapter of its latest Global Financial Stability Report to evaluating implicit subsidies to large banks, confirming that these subsidies remain substantial and suggesting that they justify further strengthening of capital requirements or taxing bank liabilities.18

Also significant has been the apparently deep frustration of both the president and Treasury Secretary Jack Lew with the pace and vigor of financial reforms. They were particularly concerned that regulators had not done enough to impose the Volcker Rule, which was finally adopted shortly before Lew’s year-end deadline.19

Yet by focusing so hard on the Volcker Rule and conflating its passage with a remedy for the fear that banks were “too big to fail,” the Obama administration may have deflected attention from the broader effort to produce a safer banking system. At its core, forceful financial regulation requires much more robust capital requirements along the lines proposed by Admati and Hellwig, Senators Brown and Vitter, and FDIC Vice-Chairman Hoenig. That is a task that has been hamstrung by the Fed’s regrettable embrace of the Basel system, and one that might have benefited greatly from committed White House support. With the Volcker Rule now on the books, the administration should drive hard for deeper financial reform.