Margaret Doyle's Profile
Leverage ratio can be a useful tool
Bank regulators are to introduce a globally-consistent leverage ratio as a supplementary measure of individual banks’ soundness.
Judging by some of the complaints the move has triggered, this may seem like a radical shift in banking regulation. In fact, leverage ratios — which limit the total amount a bank can lend relative to its capital base — are not particularly new. U.S. commercial banks have been subject to a 5 percent ratio of capital to total assets for years, and the Swiss imposed a 3 percent ratio on its two big banks at the end of last year.
Christian Noyer, governor of the Bank of France, worries that such a measure might not work: after all, American banks got into trouble just as easily as Europeans. Another concern is that a hard-line backstop for leverage takes no account of the relative riskiness of banks’ assets.
That may be so, but bankers have shown a remarkable ability to manipulate more sophisticated measures. As long as any leverage ratio is used as a diagnostic measure among many other tools within regulators’ toolkit, bankers’ bleatings should be ignored.
The Basel II framework, which has at its heart an equity ratio comparing equity to risk-weighted assets, was meant to encourage banks to lend to safer clients, and to set aside sufficient capital when lending to racier prospects. Unfortunately, regulators largely depended on banks themselves to decide what constituted a safe bet. The result was that, when the crisis hit, banks were woefully undercapitalised.
Another argument is that a leverage ratio makes no distinction between, say, government bonds, AAA-rated asset-backed securities and junk bonds. Given that banks got into trouble by piling on supposedly low-risk AAA bonds backed by U.S. sub-prime mortgages, this would appear to be a good thing. But it could have unintended consequences: Noyer frets that a leverage ratio could add to the reluctance of banks to lend on interbank markets.
Reflecting the impact of different accounting standards may prove more difficult. European banks are required to include the gross value of derivatives contracts on their balance sheets, which makes capital buffers appear smaller. U.S. banks are allowed to report net positions.
Arguably a pure leverage ratio would not allow netting: after all, the crisis showed that even a supposedly solid counterparty like AIG can go under.
Whatever the outcome of this debate, regulators acknowledge that their definition of the leverage ratio must take account of differences in accounting. That is easy to say but tough to do.
The rapid moves towards global convergence of accounting standards were stopped in their tracks by the credit crisis. A series of complex adjustments would undermine the leverage ratio’s simplicity, which is its main appeal, and could open the door for banks to manipulate the figures.
It will take more than an aspirational communiqué to get over the real differences that underlie these international spats. But a leverage ratio is a useful safety net when more sophisticated approaches to bank regulation fail. Agreeing a definition is worth the effort if banks are not to win this argument before battle has even been joined.
(Additional reporting by Paul Taylor and Neil Unmack)