Fallacies and Irrelevant Facts in the Debate on Capital Regulation

As the financial crisis of 2007–2008 has compellingly shown, highly leveraged financial institutions create negative externalities. When a bank is highly leveraged and has little equity to absorb losses, even a small decrease in asset value can lead to distress and potential insolvency. In a deeply interconnected financial system, this can cause the system to freeze, ultimately leading to severe repercussions for the rest of the economy.2 To minimize social damage, governments may feel compelled to spend large amounts on bailouts and recovery efforts. Even when insolvency is not an immediate problem, following a small decrease in asset values, highly leveraged banks may be compelled to sell substantial amounts of assets in order to reduce their leverage; such sales can put strong pressure on asset markets and prices and, thereby, indirectly on other banks.