By Peter Thal Larsen and Rolfe Winkler
LONDON/NEW YORK, Oct 5 (Reuters) – Of all the reforms proposed by global financial regulators over the past 12 months, none looks as appealingly straightforward as the leverage ratio. What could be simpler than linking the total amount of assets a bank can hold to the amount of capital it has to absorb losses it makes on them?
Alas, such a task is more difficult than it appears. There is little international agreement about how to calculate banks’ assets or capital, let alone what the ratio between the two should be.
A few years ago, even the idea of such a simple measure seemed hopelessly out of date. Banks were busy building sophisticated computer models to measure the risks they faced. They were allowed to tweak the amount of capital they held against assets depending on how risky the computer thought those assets to be. Then those models failed.
Now bank regulators want a blunt measure that will cap banks’ expansion, regardless of what their models say. Despite the complexities, they are right to try.
Still, finding a consistent way to measure banks’ assets is a daunting challenge. For instance, U.S. accounting rules allow banks to report their net derivatives exposure. International Financial Reporting Standards used by most European banks don’t. Take Deutsche Bank: At the end of 2008 its gross derivatives book accounted for nearly half its total assets of 2.2 trillion euros. Using IFRS, Deutsche’s leverage ratio is 1.3 percent but under U.S. GAAP it’s 4.2 percent.
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Regulators agree that any calculation of leverage should adjust for these differences to discourage regulatory arbitrage. But barring an unlikely shift to global accounting standards, this will undermine the leverage ratio’s simplicity, which is central to its appeal.
Measuring capital is also a thorny issue. U.S. regulators believe that only tangible equity — cash raised from shareholders or retained through earnings — should count as capital. That is sensible: Only this capital occupies the true first loss position. Without it, investors higher up the capital structure tend to panic and run for the exits when losses mount.
But the emphasis on tangible equity has gone down badly with European banks, which have historically stuffed preferred shares and other forms of hybrid capital into their capital structures. If these are excluded from capital measures, European banks will have to find tens of billions of additional equity — or shrink their balance sheets even further. Another objection is that U.S. banks are currently allowed to count deferred tax assets as capital, even though these are worthless if the institution cannot make a profit.
Even if these problems can be overcome, the leverage ratio is not foolproof. After all, U.S. regulators have long imposed a 4 percent leverage ratio on banks. But this did not include off-balance sheet assets. More recently, Swiss regulators introduced a leverage ratio for UBS and Credit Suisse that explicitly excludes the banks’ Swiss loan books from their asset calculations. Some bankers argue that, because the ratio does not adjust for balance sheet risks, it may even encourage banks to load up on risky assets.
Placing an appropriate cap on the expansion of banks’ balance sheets is crucial to the future of banking regulation. If it’s too loose, banks may rush into another crisis. If it’s not applied consistently, banks will arbitrage differences between regimes. Some will argue that if it’s too tight, banks will constrict lending or will dump safe assets in favour of risky ones.
But this misses the point. The leverage ratio is not designed to replace risk-based measures of capital: it is a safety net in case those measures fail. Despite the difficulties involved, regulators should not be deterred from introducing it.
(e-mail: peter.thal.larsen at thomsonreuters.com; rolfe.winkler at thomsonreuters.com)
Harlequin002: We might be debating at cross-purposes here. Even if you were correct, the weighted average cost of capital (WACC) of, e.g. bank, is much more complex and dynamic than a flat rate of 10%.