December 11, 2013 6:59 pm
The existing “risk-based” capital requirements have a number of shortcomings. Risk weightings are static; risk is dynamic. An asset perceived as safe one day can become risky the next. Regulatory judgments about risk are often tainted by analytic and political biases, incomplete information and the inherent uncertainties of economic forecasting. As a result, rules are overly complicated and filled with exceptions and carveouts that can create perverse incentives to favour certain assets – all while providing a false sense of security.
Adding a strong simple leverage ratio counters many of these shortcomings. It is easy to understand for management, boards, investors – and regulators. It is also comparable across companies, and in conjunction with a standardised risk-based system, difficult to game. A dual approach dramatically improves transparency about a company’s risk exposure and should allow investors and counterparties to perform apples-to-apples comparisons among large, complex institutions.
There is, however, one important caveat. In addition to raising the standards, as we on the Systemic Risk Council and other public interest groups have argued, one way to improve this approach is to fix our accounting regime to allow apples-to-apples comparisons between US institutions and their global counterparts.
Regulators have done a good job of trying to establish a leverage test to account for off-balance-sheet items given differences between US and international accounting standards, but convergence would be far superior. Many readers would be surprised just how leveraged many US institutions are, using the international standards.
The door to a safer, less leveraged financial system is half-open. We can open it wide by uniting standardised risk-based capital rules with leverage constraints, and common balance- sheet measures through convergence on global accounting standards.
The writers are former chairman of the Federal Reserve Board, and former chairman and chief executive of Citicorp and Citibank. Both are members of the Systemic Risk Council