What happened to those stringent capital adequacy stress tests that would spot and fix troubled banks well before they began to fail?
In short, Dodd-Frank was based on a misconception. It fundamentally works by limiting the amount banks can borrow without equity backstops. But you can’t be a little bit leveraged any more than you can be a little bit pregnant. The stress tests in their most stringent form assumed that 15 percent bank capital would be more than adequate. This means a bank can borrow $1 and invest 85 cents of it at risk. Consequently, if the bank suffers a 15 percent or greater loss on its assets, the bank is broke.