How to Free Big Banks From Weight of Dead Money

Excess deposits imply costs and a capital burden, more regulators should address the latter

By Paul J. Davies

Mark Carney, governor of the Bank of England. The central bank has embarked on cutting central bank reserves from leverage calculations this month. Photo: Reuters


Big banks have long complained about the costs of holding large pools of inactive deposits, especially in countries where interest rates have turned negative. Increasingly, they are charging customers to look after their cash.

But the problem isn't only that inactive cash is a drag on profits, this dead money also ties up bank equity capital, too. Now a new push is brewing to cut the capital impact and it was just given a bit of help by the Bank of England.

The equity effect is most relevant in markets where the capital demands from simple leverage ratios are close to or higher than from risk-based ratios. That mainly means Switzerland, but also the U.S.
To lessen the strain, banks such as J.P. Morgan JPM -0.09 % and UBS, which attract an outsize share of banking-system deposits, want the reserves they hold at central banks cut from calculations of the size of their balance sheets for leverage-ratio purposes. These “central bank reserves” are deposits that banks themselves keep at their central bank. They have expanded hugely as central banks created money to buy assets during the years of quantitative easing.

Removing reserves from leverage calculations could release tens of billions in equity capital at the world’s biggest banks, which in some cases could be handed back to shareholders or used to back more productive loans to the real economy.

The argument for doing this is that the deposits banks hold at a central bank are risk free—no central bank is going to fail to honor them. They are typically matched on the liabilities side of the bank balance sheets by customer deposits.

The Bank of England acknowledged this when it cut central bank reserves from leverage calculations this month. It estimated the change would reduce leverage ratio capital requirements across U.K. banks by about £11 billion ($14.4 billion).

However, U.K. banks won’t release any equity, because their capital requirements are higher under risk-weighted asset calculations than under simpler leverage calculations. Plus U.K. regulators plan to add the capital requirements back in other ways, because their only motivation for the change was to ensure future quantitative easing programs wouldn’t force banks to hold more equity.

In Switzerland, however, a similar change could make a real difference because banks have to hold more equity to meet leverage ratios than they do to meet risk-based measures.
 
For example, UBS currently holds something like Swiss francs 50 billion of Swiss central bank reserves, tieing up 1.75 billion francs of equity. If that were no longer required, it would still have a risk-based common equity capital ratio of 14%, which is more than healthy by most European standards.

In the U.S., risk-based capital calculations still produce higher equity requirements than plain leverage calculations, but U.S. leverage ratios are higher than in many European markets and more trusted by investors.

The biggest U.S. lenders want to see central bank reserves cut from leverage calculations because it could significantly cut the costs of holding inactive deposits on their balance sheets.

Banks don’t get a lot of sympathy for their profitability problems, but where monetary policy is having perverse effects, like increasing the cost of credit, regulators should act. Burying the problem of dead money would make life easier.

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