There is an essential reform of bank capital standards that is not being discussed at all in the congressional debates about financial regulation. It is to stop treating equity investments made by banks as if they were investments in debt for purposes of bank capital requirements.

If an instrument is equity for the issuer, a bank buying it should hold 100% of its own equity against it (in other words, "dollar for dollar" capital). Otherwise, the leverage of the financial system is hyped through double leverage at the system level.

Consider, for example, the preferred stock of Fannie Mae and Freddie Mac. For the political purpose of promoting housing finance, banks were encouraged by capital regulations to buy it. This preferred stock was equity able to be leveraged by Fannie and Freddie on and off their balance sheets, but in addition it was leveraged in the investing bank.

A national bank had a risk-based capital weighting of only 20%. A 20% risk weighting means the risk-based capital requirement was a mere 1.6%, so an equity investment could be levered 60 times in the bank as well as about 70 times in Fannie and Freddie. If you consider the binding constraint was a 5% leverage ratio rather than risk-based capital, the bank was still doing the equivalent of buying stock on 95% margin. The financial system result of this combined structure: virtually no net real equity.

More than 2,000 banks were suckered in to buying Fannie and Freddie preferred stock on this basis. When the value of Fannie and Freddie preferred stock went to zero, losses were massive--and the situation was naturally much worse because the stock was highly leveraged in the banks. Had the correct 100% capital requirement been in force, they would never have bought so much in the first place. The use of bank capital requirements to promote a political housing finance goal led to a double leverage disaster.

Exactly the same logic applies to banks which buy other banks' trust-preferred securities. Congress is considering whether the issuing bank should count such securities as equity. An equally important issue is: suppose it is equity for the issuer, then what is the capital requirement for a bank buyer? The correct answer: 100% equity. Otherwise, we simply have another way to double leverage the financial system.

Bank ownership of the stock of the Federal Home Loan banks should be tested by the same logic.

The rule we need is simple: if it is equity for the issuer of the instrument, the capital requirement for any bank which buys it is 100%.

Alex J. Pollock is a resident fellow at AEI.

Photo Credit: iStockphoto/DNY59.