How Should We Deal With Excessive Leverage In Banking?

Excessive leverage was an important cause of the last financial crisis.  Banks need to have a cushion of assets to absorb potential losses.  They did not have an adequate cushion in the last crisis so they were rescued by central banks which provided the cushion.  According to this article in the Financial Times,  UK banks have increased their leverage ratios again to dangerous levels (33:1).  They do so for two reasons: Bankers have an incentive to hold less equity as a cushion because their compensation is based upon the return on equity.  Politicians are reluctant to require reduced leverage because they fear that banks will reduce lending instead of raising more equity.  That would be bad for the credit based economy.  Consequently, the banking system is setting the stage for the next financial crisis.  Moreover, the problems that we see in the UK are similar to those in many other countries.

The other point, made in this article, is that an alternative method of reducing risk in the banking system is a mistake.  It argues against policies which attempt to control the flow of global capital in order to reduce risk in the banking system.  Prudential banking is preferred is preferred to capital controls.