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Banks, Borrowed Money And Bailouts

by Jacob Goldstein
Jul 10, 2013

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A proposed new rule would force big banks to rely less on borrowed money, and more on money that belongs to the banks themselves.

This rule has lots of interesting context, which includes words and phrases such as Basel, capital ratios, and risk-weighting. But here's the nub of it.

Banks get into trouble when they lose so much money that they can't pay back what they've borrowed. When the banks are big, or when it happens to lots of banks at once, this creates lots of problems for everyone. It can lead to bailouts. The less banks rely on borrowed money in the first place, the more they can lose without causing problems for everyone.

Banks, on the other hand, like relying very heavily on borrowed money, largely for a pretty simple reason. As Matt Levine wrote recently for us:

...banks - and their shareholders - tend to like leverage, which is the superpower that borrowed money creates. Borrowing money - especially when you can borrow it really cheaply, like you can today - allows you to magnify your profits and losses. Magnifying your profits is good for shareholders (they get the profits!). Magnifying your losses isn't great, but since the shareholders don't necessarily suffer all of the losses (their shares can't go below zero), they might still prefer to take the risk.

That said, the whole point of banks is to borrow money from some people — namely, ordinary people with checking and savings accounts — and lend it out to others. That's basic, old-fashioned banking, and there's broad (but not universal) agreement that banks should continue to work this way. The proposed new rule, which really is a pretty big deal, would still let banks rely almost entirely on borrowed money.

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