Skip to main content
Menu

Main navigation

  • About
    • Annual Reports
    • Leadership
    • Jobs
    • Student Programs
    • Media Information
    • Store
    • Contact
    LOADING...
  • Experts
    • Policy Scholars
    • Adjunct Scholars
    • Fellows
  • Events
    • Upcoming
    • Past
    • Event FAQs
    • Sphere Summit
    LOADING...
  • Publications
    • Studies
    • Commentary
    • Books
    • Reviews and Journals
    • Public Filings
    LOADING...
  • Blog
  • Donate
    • Sponsorship Benefits
    • Ways to Give
    • Planned Giving

Issues

  • Constitution and Law
    • Constitutional Law
    • Criminal Justice
    • Free Speech and Civil Liberties
  • Economics
    • Banking and Finance
    • Monetary Policy
    • Regulation
    • Tax and Budget Policy
  • Politics and Society
    • Education
    • Government and Politics
    • Health Care
    • Poverty and Social Welfare
    • Technology and Privacy
  • International
    • Defense and Foreign Policy
    • Global Freedom
    • Immigration
    • Trade Policy
Live Now

Blog


  • Blog Home
  • RSS

Email Signup

Sign up to have blog posts delivered straight to your inbox!

Topics
  • Banking and Finance
  • Constitutional Law
  • Criminal Justice
  • Defense and Foreign Policy
  • Education
  • Free Speech and Civil Liberties
  • Global Freedom
  • Government and Politics
  • Health Care
  • Immigration
  • Monetary Policy
  • Poverty and Social Welfare
  • Regulation
  • Tax and Budget Policy
  • Technology and Privacy
  • Trade Policy
Archives
  • March 2021
  • February 2021
  • January 2021
  • December 2020
  • November 2020
  • October 2020
  • September 2020
  • August 2020
  • July 2020
  • June 2020
  • May 2020
  • April 2020
  • March 2020
  • February 2020
  • January 2020
  • December 2019
  • November 2019
  • October 2019
  • September 2019
  • August 2019
  • July 2019
  • June 2019
  • May 2019
  • April 2019
  • March 2019
  • February 2019
  • January 2019
  • December 2018
  • November 2018
  • October 2018
  • September 2018
  • August 2018
  • July 2018
  • June 2018
  • May 2018
  • April 2018
  • March 2018
  • February 2018
  • January 2018
  • December 2017
  • November 2017
  • October 2017
  • September 2017
  • August 2017
  • July 2017
  • June 2017
  • May 2017
  • April 2017
  • March 2017
  • February 2017
  • January 2017
  • December 2016
  • November 2016
  • October 2016
  • September 2016
  • August 2016
  • July 2016
  • June 2016
  • May 2016
  • April 2016
  • March 2016
  • February 2016
  • January 2016
  • December 2015
  • November 2015
  • October 2015
  • September 2015
  • August 2015
  • July 2015
  • June 2015
  • May 2015
  • April 2015
  • March 2015
  • February 2015
  • January 2015
  • December 2014
  • November 2014
  • October 2014
  • September 2014
  • August 2014
  • July 2014
  • June 2014
  • May 2014
  • April 2014
  • March 2014
  • February 2014
  • January 2014
  • December 2013
  • November 2013
  • October 2013
  • September 2013
  • August 2013
  • July 2013
  • June 2013
  • May 2013
  • April 2013
  • March 2013
  • February 2013
  • January 2013
  • December 2012
  • November 2012
  • October 2012
  • September 2012
  • August 2012
  • July 2012
  • June 2012
  • May 2012
  • April 2012
  • March 2012
  • February 2012
  • January 2012
  • December 2011
  • November 2011
  • October 2011
  • September 2011
  • August 2011
  • July 2011
  • June 2011
  • May 2011
  • April 2011
  • March 2011
  • February 2011
  • January 2011
  • December 2010
  • November 2010
  • October 2010
  • September 2010
  • August 2010
  • July 2010
  • June 2010
  • May 2010
  • April 2010
  • March 2010
  • February 2010
  • January 2010
  • December 2009
  • November 2009
  • October 2009
  • September 2009
  • August 2009
  • July 2009
  • June 2009
  • May 2009
  • April 2009
  • March 2009
  • February 2009
  • January 2009
  • December 2008
  • November 2008
  • October 2008
  • September 2008
  • August 2008
  • July 2008
  • June 2008
  • May 2008
  • April 2008
  • March 2008
  • February 2008
  • January 2008
  • December 2007
  • November 2007
  • October 2007
  • September 2007
  • August 2007
  • July 2007
  • June 2007
  • May 2007
  • April 2007
  • March 2007
  • February 2007
  • January 2007
  • December 2006
  • November 2006
  • October 2006
  • September 2006
  • August 2006
  • July 2006
  • June 2006
  • May 2006
  • April 2006
  • Show More
May 12, 2016 9:23AM

Two Cheers for the Leverage Ratio

By Kevin Dowd

SHARE

In a previous blog posting, I suggested that there is no case for capital adequacy regulation in an unregulated banking system.  In this ‘first-best’ environment, a bank’s capital policy would be just another aspect of its business model, comparable to its lending or reserving policies, say.  Banks’ capital adequacy standards would then be determined by competition and banks with inadequate capital would be driven out of business.

Nonetheless, it does not follow that there is no case for capital adequacy regulation in a ‘second-best’ world in which pre-existing state interventions — such as deposit insurance, the lender of last resort and Too-Big-to-Fail — create incentives for banks to take excessive risks.  By excessive risks, I refer to the risks that banks take but would not take if they had to bear the downsides of those risks themselves.

My point is that in this ‘second-best’ world there is a ‘second-best’ case for capital adequacy regulation to offset the incentives toward excessive risk-taking created by deposit insurance and so forth.  This posting examines what form such capital adequacy regulation might take.

At the heart of any system of capital adequacy regulation is a set of minimum required capital ratios, which were traditionally taken to be the ratios of core capital[1] to some measure of bank assets.

Under the international Basel capital regime, the centerpiece capital ratios involve a denominator measure known as Risk-Weighted Assets (RWAs).  The RWA approach gives each asset an arbitrary fixed weight between 0 percent and 100 percent, with OECD government debt given a weight of a zero.  The RWA measure itself is then the sum of the individual risk-weighted assets on a bank’s balance sheet.

The incentives created by the RWA approach turned Basel into a game in which the banks loaded up on low risk-weighted assets and most of the risks they took became invisible to the Basel risk measurement system.

The unreliability of the RWA measure is apparent from the following chart due to Andy Haldane:

Figure 1: Average Risk Weights and Leverage

Media Name: average-rwas.png

This chart shows average Basel risk weights and leverage for a sample of international banks over the period 1994–2011.  Over this period, average risk weights show a clear downward trend, falling from just over 70 percent to about 40 percent.  Over the same period, bank leverage or assets divided by capital — a simple measure of bank riskiness — moved in the opposite direction, rising from about 20 to well over 30 at the start of the crisis.  The only difference is that while the latter then reversed itself, the average risk weight continued to fall during the crisis, continuing its earlier trend.  “While the risk traffic lights were flashing bright red for leverage [as the crisis approached], for risk weights they were signaling ever-deeper green,” as Haldane put it: the risk weights were a contrarian indicator for risk, indicating that risk was falling when it was, in fact, increasing sharply.[2]  The implication is that the RWA is a highly unreliable risk measure.[3]

Long before Basel, the preferred capital ratio was core capital to total assets, with no adjustment in the denominator for any risk-weights.  The inverse of this ratio, the bank leverage measure mentioned earlier, was regarded as the best available indicator of bank riskiness: the higher the leverage, the riskier the bank.

These older metrics then went out of fashion.  Over 30 years ago, it became fashionable to base regulatory capital ratios on RWAs because of their supposedly greater ‘risk sensitivity.’  Later the risk models came along, which were believed to provide even greater risk sensitivity.  The old capital/assets ratio was now passé, dismissed as primitive because of its risk insensitivity.  However, as RWAs and risk models have themselves become discredited, this risk insensitivity is no longer the disadvantage it once seemed to be.

On the contrary.

The old capital to assets ratio is making a comeback under a new name, the leverage ratio:[4] what is old is new again.  The introduction of a minimum leverage ratio is one of the key principles of the Basel III international capital regime.  Under this regime, there is to be a minimum required leverage ratio of 3 percent to supplement the various RWA-based capital requirements that are, unfortunately, its centerpieces.

The banking lobby hate the leverage ratio because it is less easy to game than RWA-based or model-based capital rules.  They and their Basel allies then argue that we all know that the RWA measure is flawed, but we shouldn’t throw out the baby with the bathwater.  (What baby? I ask. RWA is a pretend number and it’s as simple as that.)  They then assert that the leverage ratio is also flawed and conclude that we need the RWA to offset the flaws in the leverage ratio.

The flaw they now emphasize is the following: a minimum required leverage ratio would encourage banks to load up on the riskiest assets because the leverage ratio ignores the riskiness of individual assets.  This argument is commonly made and one could give many examples.  To give just one, a Financial Times editorial — ironically entitled “In praise of bank leverage ratios” — published on July 10, 2013 stated flatly:

Leverage ratios …  encourage lenders to load up on the riskiest assets available, which offer higher returns for the same capital.

Hold on right there!  Those who make such claims should think them through: if the banks were to load up on the riskiest assets, we first need to consider who would bear those higher risks.

The FT statement is not true as a general proposition and it is false in the circumstances that matter, i.e., where what is being proposed is a high minimum leverage ratio that would internalize the consequences of bank risk-taking.  And it is false in those circumstances precisely because it would internalize such risk-taking.

Consider the following cases:

In the first, imagine a bank with an infinitesimal capital ratio.  This bank benefits from the upside of its risk-taking but does not bear the downside.  If the risks pay off, it gets the profit; but if it makes a loss, it goes bankrupt and the loss is passed to its creditors.  Because the bank does not bear the downside, it has an incentive to load up on the riskiest assets available in order to maximize its expected profit.  In this case, the FT statement is correct.

In the second case, imagine a bank with a high capital-to-assets ratio.  This bank benefits from the upside of its risk-taking but also bears the downside if it makes a loss.  Because the bank bears the downside, it no longer has an incentive to load up on the riskiest assets.  Instead, it would select a mix of low-risk and high-risk assets that reflected its own risk appetite, i.e., its preferred trade-off between risk and expected return.  In this case, the FT statement is false.

My point is that the impact of a minimum required leverage ratio on bank risk-taking depends on the leverage ratio itself, and that it is only in the case of a very low leverage ratio that banks will load up on the riskiest assets.  However, if a bank is very thinly capitalized then it shouldn’t operate at all.  In a free-banking system, such a bank would lose creditors’ confidence and be run out of business.  Even in the contemporary United States, such a bank would fall foul of the Prompt Corrective Action statutes and the relevant authorities would be required to close it down.

In short, far from encouraging excessive risk-taking as is widely believed, a high minimum leverage ratio would internalize risk-taking incentives and lead to healthy rather than excessive risk-taking.

Then there is the question of how high ‘high’ should be.  There is of course no single magic number, but there is a remarkable degree of expert consensus on the broad order of magnitude involved.  For example, in an important 2010 letter to the Financial Times drafted by Anat Admati, she and 19 other renowned experts suggested a minimum required leverage ratio of at least 15 percent — at least five times greater than under Basel III — and some advocate much higher minima.  Independently, John Allison, Martin Hutchinson, Allan Meltzer and yours truly have also advocated minimum leverage ratios of at least 15 percent.  By a curious coincidence, 15 percent is about the average leverage ratio of U.S. banks at the time the Fed was founded.

There is one further and much under-appreciated benefit from a leverage ratio.  Suppose we had a leverage ratio whose denominator was not total assets or some similar measure.  Suppose instead that its denominator was the total amount at risk: one would take each position, establish the potential maximum loss on that position, and take the denominator to be the sum of these potential losses.  A leverage-ratio capital requirement based on a total-amount-at-risk denominator would give each position a capital requirement that was proportional to its riskiness, where its riskiness would be measured by its potential maximum loss.

Now consider any two positions with the same fair value.  With a total asset denominator, they would attract the same capital requirement, independently of their riskiness.  But now suppose that one position is a conventional bank asset such as a commercial loan, where the most that could be lost is the value of the loan itself.  The other position is a long position in a Credit Default Swap (i.e., a position in which the bank sells credit insurance).  If the reference credit in the CDS should sharply deteriorate, the long position could lose much more than its current value.  Remember AIG! Therefore, the CDS position is much riskier and would attract a much greater capital requirement under a total-amount-at-risk denominator.

The really toxic positions would be revealed to be the capital-hungry monsters that they are.  Their higher capital requirements would make many of them unattractive once the banks themselves were to made to bear the risks involved.  Much of the toxicity in banks’ positions would soon disappear.

The trick here is to get the denominator right.  Instead of measuring positions by their accounting fair values as under, e.g., U.S. Generally Accepted Accounting Principles, one should measure those positions by how much they might lose.

Nonetheless, even the best-designed leverage ratio regime can only ever be a second-best reform: it is not a panacea for all the ills that afflict the banking system.  Nor is it even clear that it would be the best ‘second-best’ reform: re-establishing some form of unlimited liability might be a better choice.

However, short of free banking, under which no capital regulation would be required in the first place, a high minimum leverage ratio would be a step in the right direction.

_____________

[1] By core capital, I refer the ‘fire-resistant’ capital available to support the bank in the heat of a crisis.  Core capital would include, e.g., tangible common equity and some retained earnings and disclosed reserves.  Core capital would exclude certain ‘softer’ capital items that cannot be relied upon in a crisis.  An example of the latter would be Deferred Tax Assets (DTAs).  DTAs allow a bank to claim back tax on previously incurred losses in the event it subsequently returns to profitability, but are useless to a bank in a solvency crisis.

[2] A. G. Haldane, “Constraining discretion in bank regulation.” Paper given at the Federal Reserve Bank of Atlanta Conference on ‘Maintaining Financial Stability: Holding a Tiger by the Tail(s)’, Federal Reserve Bank of Atlanta 9 April 2013, p. 10.

[3] The unreliability of the RWA measure is confirmed by a number of other studies.  These include, e.g.: A. Demirgüç-Kunt, E. Detragiache, and O. Merrouche, “Bank Capital: Lessons from the Financial Crisis,” World Bank Policy Research Working Paper Series No. 5473 2010); A. N. Berger and C. H. S. Bouwman, “How Does Capital Affect Bank Performance during Financial Crises?” Journal of Financial Economics 109 (2013): 146–76; A. Blundell-Wignall and C. Roulet, “Business Models of Banks, Leverage and the Distance-to-Default,” OECD Journal: Financial Market Trends 2012, no. 2 (2014); T. L. Hogan, N. Meredith and X. Pan, “Evaluating Risk-Based Capital Regulation,” Mercatus Center Working Paper Series No. 13-02 (2013); and V. V. Acharya and S. Steffen, “Falling short of expectation — stress testing the Eurozone banking system,” CEPS Policy Brief No. 315, January 2014.

[4] Strictly speaking, Basel III does not give the old capital-to-assets ratio a new name.  Instead, it creates a new leverage ratio measure in which the old denominator, total assets, is replaced by a new denominator measure called the leverage exposure.  The leverage exposure is meant to take account of the off-balance-sheet positions that the total assets measure fails to include.  However, in practice, the leverage exposure is not much different from the total assets measure, and for present purposes one can ignore the difference between the two denominators.  See Basel Committee on Banking Supervision, “Basel III: A global regulatory framework for more resilient banks and banking systems.”  Basel: Bank for International Settlements, June 2011, pp. 62-63.

[Cross-posted from Alt-M.org]

Related Tags
Finance, Banking & Monetary Policy

Stay Connected to Cato

Sign up for the newsletter to receive periodic updates on Cato research, events, and publications.

View All Newsletters

1000 Massachusetts Ave, NW,
Washington, DC 20001-5403
(202) 842-0200
Contact Us
Privacy

Footer 1

  • About
    • Annual Reports
    • Leadership
    • Jobs
    • Student Programs
    • Media Information
    • Store
    • Contact

Footer 2

  • Experts
    • Policy Scholars
    • Adjunct Scholars
    • Fellows
  • Events
    • Upcoming
    • Past
    • Event FAQs
    • Sphere Summit

Footer 3

  • Publications
    • Books
    • Cato Journal
    • Regulation
    • Cato Policy Report
    • Cato Supreme Court Review
    • Cato’s Letter
    • Human Freedom Index
    • Economic Freedom of the World
    • Cato Handbook for Policymakers

Footer 4

  • Blog
  • Donate
    • Sponsorship Benefits
    • Ways to Give
    • Planned Giving
Also from Cato Institute:
Libertarianism.org
|
Humanprogress.org
|
Downsizinggovernment.org