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.In good times, individuals and corporations borrow andspend more on consumer goods.Individuals and corporations mayalso spend borrowed money on income-producing assets like real estate.Similarly, in good times, the capital of banks is rising under Basel II.Consequently, banks are prepared to lend more money and buy moreassets.If enough money chases the same assets, asset bubbles canform such as our recent housing bubble.The negative procyclical effects of borrowed money happen wheneconomies decline.During economic recessions, unemploymentincreases and asset values decrease.Both factors increase loan losses atbanks because unemployed individuals are less able to make debt pay-ments, and falling asset values mean banks receive less at auction forrepossessed loan collateral.Under Basel II, rising losses at banks reducetheir capital, making them curtail their lending.As a result, it becomesmore expensive for businesses to finance expansion projects.Consumersalso decrease their spending, because they are worried about the econ-omy, and they are feeling poorer because their home and investmentportfolios have just declined in value.To illustrate the negative procyclical effects of borrowed money onfinancial firms, consider the example of Bear Stearns.Prior to its forcedacquisition by J.P.Morgan in March of 2008, Bear Stearns had less than 150 t oo bi g t o s a ve ?$12 billion of tangible equity backing assets of $395 billion, translat-ing into a leverage ratio of more than 33 to 1.66 This meant that just a3 percent decline in asset value would have been enough to wipe outalmost all of the firm s equity capital.Even worse, a large portion ofBear s assets were funded by short-term borrowed money.This meantthat if enough short-term lenders asked for their money back at once,Bear would have to raise cash by selling assets quickly at a loss.Because too much fi nancial leverage causes procyclical-ity, the solution is to mandate greater buffers of equity capital.Specifi cally, banks should build up a substantial capital cush-ion during good times to ensure an adequate margin of safetyduring bad times.As recommended by former Fed Chairman PaulVolcker and the Group of 30, regulators should accomplish this goalby raising the regulatory range for being well-capitalized during goodtimes.67 In those times, financial institutions should operate at the top ofthe range, because the worst loans are typically originated during goodtimes.Furthermore, very large fi nancial institutions should gen-erally hold more capital than smaller institutions.Because theseinstitutions are likely to be bailed out at the taxpayers expense,the United States should reduce their risk of failure by askingthem to hold more capital than usual.68 In good times, for example,a bank might be classified as well-capitalized if its Tier 1 capital relativeto risk-based assets was in the 8 10 percent range, instead of 6 percentas currently.Similarly, a bank might be classified as well-capitalized if itstotal capital (Tier 1 plus Tier 2) relative to risk-based assets was in the12 to 14 percent range, instead of the current 10 percent.During goodeconomic times, banks would be expected to maintain capital levels nearthe top of these ranges to act as a buffer against subsequent downturns.69SummaryThe fi ve largest investment banks in the United States Bear Stearns,Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley(the Five Investment Banks) were transformed during 2008.Twofailed, one was acquired, and two converted to bank holding companies.The SEC facilitated the transformation of these Five Investment Banks Capital Requirements at Brokers and Banks 151by allowing them to more than double their leverage ratios.In addi-tion, the SEC s new program for consolidated supervision of the FiveInvestment Banks was ineffective.Nevertheless, the concept of consolidated supervision is criticalto a viable regulatory system for diversified financial conglomerates.Because each of the financial services is regulated by a different agency,one government body needs to have supervisory authority over theconsolidated group to prevent regulatory gaps and to monitor transac-tions within the group.The Federal Reserve plays this role for bankinggroups, and the SEC should play this role for any broker-dealer notwithin a banking group.A state can serve as the consolidated supervisorfor most insurers, which are currently chartered and regulated by thestates.However, Congress should authorize a federal charter for a smallnumber of U.S.-based, global life insurers with a new federal agency tosupervise the consolidated group of each such insurer.The repeal of the Glass Steagall Act was at most a minor factorcontributing to the current fi nancial crisis.A decade before its repeal,federal regulators allowed banks and bank holding companies to dealand underwrite in most stocks and most bonds.The recent problemsof the banking industry are mainly due to credit losses on loans andbonds, rather than their underwriting activities.Moreover, universalbanks are superior formats to stand-alone investment banks because thelatter rely primarily on commercial paper and repurchase agreementsfor short-term financing, whereas the former have two more sources ofshort-term financing: insured deposits and Federal Reserve loans.Because all the Five Investment Banks have become parts of bank-ing organizations, the capital requirements for banks have become evenmore important.Basel I, which was in effect until the beginning of2008, encouraged a bank to hold subprime mortgages because theywere subject to only half the normal 8 percent capital requirement, andhighly rated MBS because they were subject to only one-fourth thenormal 8 percent capital requirement.Basel I also did not address manyof the capital market transactions in which banks participated.Although Basel II provides a more refi ned set of capital rules thanBasel I, the new rules are too dependent on the rating of bonds bycredit-rating agencies and assessments by internal bank risk models.In addition, the new rules are devilishly complex and give too little 152 t oo bi g t o s a ve ?attention to liquidity risk
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