As the financial crisis of 2007–2008 has compellingly shown, highly leveraged financial institutions create negative externalities. When a bank is highly leveraged and has little equity to absorb losses, even a small decrease in asset value can lead to distress and potential insolvency. In a deeply interconnected financial system, this can cause the system to freeze, ultimately leading to severe repercussions for the rest of the economy. To minimize social damage, governments may feel compelled to spend large amounts on bailouts and recovery efforts. Even when insolvency is not an immediate problem, following a small decrease in asset values, highly leveraged banks may be compelled to sell substantial amounts of assets in order to reduce their leverage; such sales can put strong pressure on asset markets and prices and, thereby, indirectly on other banks.
Avoidance of such “systemic risk” and the associated social costs is a major objective of financial regulation. Because market participants, acting in their own interests, tend to pay too little attention to systemic concerns, financial regulation and supervision are intended to step in and safeguard the functioning of the financial system. Given the experience of the recent crisis, it is natural to consider a requirement that banks have significantly less leverage—that is, that they use relatively more equity funding so that inevitable variations in asset values do not lead to distress and insolvency.
A pervasive view that underlies most discussions of capital regulation is that “equity is expensive,” and that equity requirements, while offering substantial benefits in preventing crises, also impose costs on the financial system, and possibly on the economy. Bankers have mounted a campaign against increasing equity requirements. Policymakers and regulators are particularly concerned by assertions that increased equity requirements would restrict bank lending and would impede economic growth. Possibly, as a result of such pressure, the proposed Basel III requirements, while moving in the direction of increasing capital, still allow banks to remain very highly leveraged (Blundell-Wignall et al., this volume). We consider this very troubling, because, as we show below, the view that equity is expensive is flawed in the context of capital regulation.