When the Fed and OCC released proposed revisions to the enhanced supplementary leverage ratio (eSLR), the theological squabble began anew over the one true way to impose capital on giant banks.  Is risk-based capital really the devil’s plaything, allowing big banks to sin with impunity clothed in complex models?  Could be, but there’s a better way to judge financial policy:  follow the money.  Worship or revile a rule in theory, but reality is dictated by what banks – for-profit firms at least sort of and so far –  do in response to any change in monetary or regulatory policy.  Although U.S. regulators are still blind to the inequality impact of the post-crisis leverage standards, they have now seen how the money moved in financial markets when the eSLR imposed its sin tax – the eSLR made it hard for big banks to make money in these markets so big banks abandoned them.  Same goes for equality-critical lending, about which policy-makers should care as much as they do about repos, central-clearing, and custody banks.

Does following the money make big banks sinners?  Theology dictates self-sacrifice, but shareholders are notably agnostic, if not outright atheistic.  It’s for this reason that I quoted Ray Dalio in recent remarks to the Fed observing that financial people think about the world very differently than economists.  It’s people such as Ray Dalio who then determine policy outcome, not theoretical cost-benefit analyses on which the eSLR and indeed all too many other post-crises rules are premised.

If one works not from what financial markets “should” do in response to changing policy, but what in fact they do do, it’s easier to see how well-intentioned theory leads to unanticipated and often destructive consequences.  What does following the money tell one about the new eSLR proposal? 

The NPR finally recognizes the analysis we presented in 2015 and again in 2016 that punitive leverage ratios on low-risk, low-return assets alter bank balance sheets in favor of higher-risk, higher-return obligations or fee-based businesses.  This isn’t just because of the eSLR, it’s also due to the interaction of the leverage ratio with risk-based standards and the stress tests that then are supposed to bind banks to enough regulatory capital to make them bullet-proof.  As a result, the new eSLR’s impact will be driven as much by how the Fed finalizes the proposed CCAR standards as by the eSLR rewrite.

Further complicating follow-the-money analytics is the LCR and, if the U.S. ever issues it, the net stable funding ratio.  Liquidity rules dictate how much of a big bank’s balance sheet has to be dedicated to  low-risk assets, with these amounts and the combined impact of leverage and risk-based capital rules then dictating what banks do in practice, not theory.

Can anyone tell now what the sum total impact of all of these rules will be?  When academics and regulators sought to understand the sum total impact of all of the current rules, they threw up their hands due to daunting complexity only hinted at in my assessment above.  What I do know is that regulators should look not to theory but to actual market experience to anticipate the cumulative effects of changing the eSLR and CCAR in the face of current liquidity regulation, rising interest rates, and market volatility.  We can and should argue about leverage, CCAR, liquidity regulation, and the like, but there’s one indisputable tenet that should guide regulatory action:  in financial markets money will always be made because no one is in the financial market in hopes of sainthood.