Should financial firms be strictly limited in their ability to leverage capital?
Many countries have a reserve requirement for banks, where banks cannot loan the full value of their deposits, but must reserve a small percentage (e.g. 10%). The trade-off between a low vs. high reserve ratio is between increasing liquidity and economic activity vs. safeguarding against risk. In recent years, financial firms have used exotic financial instruments such as derivatives, which in effect reduce reserve requirements, and furthermore, make the risk itself very difficult to calculate.
