Leverage Cycle

The Wall Street Journal has a nice discussion of the "leverage cycle" that underpinned, to a large extent, the credit bubble and crunch. Summarizing, the article points out that over the years 2000-2006, collateral requirements were drastically reduced for home purchases, and compares the economy wide margin-call on home loans to the collapse of LTCM in 1998. Ultimately, the theory developed by Professor Geanakoplos boils down to:

• "When banks set margins very low, lending more against a given amount of collateral, they have a powerful effect on...buyers, whether hedge funds or aspiring homeowners, who for various reasons place a higher value on a given type of collateral....Using large amounts of borrowed money, or leverage, these buyers push up prices to extreme levels."

What is not discussed are reasons that banks would set margins lower in the first place. Yes, the model of a bank is to take in money (deposits) for which they offer a minimal interest rate, and loan that money back out at a higher rate (spread). So, the more money they can loan out, the more money they can make. There are a few ways to do this, with some of the most obvious being take in more deposits, or increase the amount that people can borrow. Banking efforts to draw in more deposits are very apparent, with what feels like every other commercial detailing how your money would be better served at a particular institution.

However, what isn't as obvious are the lending standards, which the article above touches on as the source of the current leverage cycle. Key to lending standards are the regulations set by central banks and government authorities (capital requirements being a prime example). As those standards were relaxed over the past decade, banks took advantage of the new standards to maximize their business. Note, maximize, not optimize. The WSJ article completely ignores this relationship, and in fact states that the economic models should be adjusted to allow central banks to better manage the cycles. Would this not just start the inflation of another bubble, of a different asset class, as the regulations try to balance the growth of the economy?