Although the Brown-Vitter bill has big banks in an uproar, FDIC Vice Chairman Hoenig’s speech earlier this week points to a far more imminent challenge. According to the American Banker, Mr. Hoenig plans to bolster his critique of risk-based capital by making a very high leverage standard the price of final agreement on something sort of like Basel III. In my view, he could do it, buoyed now by Basel’s own doubts about its rules and a torrent of criticism about regulatory-capital arbitrage trades that regulators have done little to quash.

Why all the love for leverage? Several articles last week compared bank capital to a house down payment, arguing that it makes no sense to let banks “get away” with a three percent leverage ratio – let alone stand-alone risk-based capital (RBC) – when borrowers are said to need a twenty percent down payment for a prudent loan. However, on closer look, the analogy is inapplicable. First, capital isn’t the only bulwark banks are required to hold. Analysts who say so forget about the billions in loan-loss reserves held against expected loss. Importantly, capital is for unexpected loss, it’s the storm cellar, not an umbrella. Second, borrowers don’t need twenty percent down if their loan is well under-written and backed by capitalized third-party credit enhancement. There’s lots of data to demonstrate that, when a low down payment mortgage is both backed by private mortgage insurance and properly underwritten, its probability of default and loss given default go way, way down. Under leverage, none of this risk reduction is recognized, meaning that low-income and first-time homeowners would go begging for mortgages for no good reason.

On its face, RBC makes a lot more sense than a simple leverage standard, no matter how high Messrs. Hoenig, Norton, Haldane, Brown and Vitter set it. The reason is that leverage assumes all assets have the same risk, which they don’t. Continuing on the mortgage theme, take a mortgage-backed security. Under the leverage rule, the MBS has the same capital requirement – say five percent for a “well-capitalized” U.S. bank. Under RBC, the risk for the MBS ranges from zero – if it’s backed by Ginnie Mae – to more than dollar-for-dollar capital (i.e., a capital charge that costs the bank more than the nominal value of the MBS). And, that’s just under the credit RBC requirements. MBS can be held in a bank’s trading book, where risk weightings vary based on very different factors that, for example, take maturity into account so that capital isn’t based just on whether a bank could be repaid if time permits, but rather on whether the trading bet backed by the MBS has a reasonable chance of coming off as planned.

Under the simple leverage standards, all of these differences would be washed away. Thus, the market-risk based capital rules – complex and problematic to be sure – would disappear on grounds that an asset-based credit standard suffices. Under it, a bank would hold the same amount of capital – ten, fifteen or whatever percent – on a fully-guaranteed senior position in an MBS and on the highest risk tranche in a structured securitization. Guess where the arbitrage incentives will drive the money.

Is capital arbitrage a real risk if regulators look the other way? The hard lessons of RBC and leverage together make this all too clear. The combination of simple leverage standards and crude RBC – enabled in part by undue reliance on credit rating agencies – created much of the subprime mortgage crisis. Why? An AAA-rated security had a twenty percent weighting and a five percent leverage standard even if it was comprised of very high loan-to-value mortgages without documentation to high-risk borrowers. The high returns on these MBS permitted banks to earn a particularly juicy return on capital – a core earnings criterion, one not achievable with prudent mortgages bundled into a comparably-rated MBS. If return on capital had been risk-adjusted properly, as the more complete version of this earnings criterion would have it, then the return would have been lower. But, seduced by the combination of RBC, which vastly under-weighted the risky MBS – and leverage – which wholly failed to correct for it, the short version of this story is “Wow.” And, thus, a systemic crisis was borne.

The U.S. had leverage and it didn’t and still doesn’t work. The most recent example of particularly sophisticated structuring shows why. Here, U.S. banks have used high-cost, complex structured and synthetic securitizations to game the RBC requirements unconstrained by leverage. In a well-publicized case, Citibank used Blackstone’s nifty structuring engineers to reduce RBC by as much as ninety percent for a big book of bad shipping loans. These stayed on the bank’s balance sheet for leverage purposes – the word “synthetic” means the assets stayed put. But, because the leverage rule is so small relative to risk as to make this just an annoyance, structure proceeded apace. Leverage would need to go to dollar-for-dollar in some cases to constrain such arbitrage – see above – but doing this across the board would end banking as we know it. Simple, sure, but deadly.

Regulators have been talking about shutting down these flights of RBC fancy foot-work for years because they understand well the incentive built into RBC rules that permit this: full recognition of even uncapitalized providers of credit risk mitigation. But understand as they do and talk as they must, act they cannot seem to do. Would a ten percent leverage rule cure this? A fifteen percent standard? Maybe. But, it could also create even stronger incentives for banks to work around nominal capital barriers to unduly risky fun and games, especially if risks are taken in areas outside the reach of the leverage rule. These lie not just in the trading book, but also in the ability to short-cut needed controls or bet with other people’s money – operational risk. Leverage also doesn’t address the ability of banks to fund short to risk long – liquidity risk not captured in a simple leverage standard. Nor to take such liberties with brokered deposits and other benefits in the pursuit of predatory products as to incur lethal reputational risk – also outside the scope of a leverage rule. RBC doesn’t capture all this either, but at least it doesn’t pretend too and, thus, it’s nowhere near as dangerous.

Will big banks be better under a very high leverage rule? No, if that’s the only control on their propensity to err. Mr. Hoenig argues that supervisors will ensure that leverage works as wanted. But, in a speech yesterday, Mr. Haldane – the U.K.’s leverage aficionado – noted that there are now three bank supervisors for each U.S. bank. More needed? How many more doing what how much better?

What’s the real risk remedy? I go back to something a lot simpler than leverage: truth and punishment. If regulators come out from behind the curtain – say by disclosing their CAMELS ratings in concert with stress-test results – we’d know more not just about banks, but also their ability to spot risk and, then, stop it. If boards fail to rein in troublesome risk practices and, then, are sacked, fewer directors will kowtow to CEOs. If living wills matter – see the speech this week by the head of the Richmond Fed – banks would need to ensure they can fail under bankruptcy, and markets would step in where boards do not. In short, if regulators are accountable, boards held liable and shareholders and creditors are on their own, complex banks get a lot simpler because their incentives are far better based on risk.