Politicians and bank regulators across the world have come to the conclusion that excessive leverage, that is too much debt relative to equity, contributed to the depth of our recent financial crisis.  Their solution:  require banks to have more capital.  If only it were so easy.

As Raghuram Rajan points out in a recent piece for the Financial Times, “banks will not be passive in the face of regulatory change.”  Indeed, they will not.  For instance, if you simply double a bank’s minimum required capital, the bank could respond by doubling the risk of loans on its portfolio.   You move capital 8% to 16%, the bank can makes loans that default with expected losses at 16% and you haven’t done anything to reduce the risk in the system.

The problem with excessive leverage in our financial system was not that there was too much debt, but that debt-holders believed they would be bailed-out and hence provided little to no monitoring of bank activities.  Reducing leverage does not increase the incentives of debt-holders to monitor, in fact it may reduce it, because debt-holders will now believe there is an even bigger cushion before they take any losses.

Why is it important for debt-holders to monitor the behavior of banks anyway?  Because they are the largest piece of a bank’s capital structure.  With an 8% equity stake, debt makes up 92% of the capital structure; with even a 16% equity stake, debt is still 84% of the capital structure.  If there is no market discipline on debt-holders, then we essentially have no market discipline.

So how then to give debt-holders the appropriate incentives to monitor bank behavior?  Quite simple, put them on the hook for losses.  Rajan suggests we create “contingent capital” - debt that would convert to equity if capital levels fell below a certain level.  While the devil is in the details, providing some system to impose losses on debt-holders is essential if we ever want to have functioning financial markets.  Simply raising capital requirements does not solve that problem.