Inside Business
February 13, 2012 5:34 pm
Leverage cap has the power to reshape banking
In the real world, leverage means power over someone or something. In banking, it stands for the ability to support a wide variety of lending and investment activities using only a relatively small amount of capital.
In good times, leverage allows a tiny base to spread upward and outward like a tree, fostering growth and generating profits. In bad times, when asset prices fall rapidly, high leverage can leave a bank or hedge fund without enough cash and equity to withstand losses. In high winds, the tree risks being blown over.
After the 2008 fiasco, regulators, determined to prevent a repetition, became convinced that a mandatory cap on leverage would make the system more stable. A leverage ratio not only limits overall borrowing by banks - linking the size of the tree to its root structure - but also addresses a dangerous weakness in the main measure of bank safety, the core tier one capital ratio.
Like leverage, capital is expressed as equity over assets, but the assets are weighted using complex internal models. In theory, banks have to hold more capital against risky trading and complex products than they need for safe lending to top rated borrowers. In reality, risk-weighted assets (RWAs) are vulnerable to regulatory arbitrage, such as when collateralised debt obligations were constructed to turn pools of risky loans into supposedly safe securities before the crisis. RWAs can also be affected by collective blindness, such the fact that all sovereign bonds have historically been considered risk-free with a zero weighting.
Some Bank of England officials, for example, see a leverage ratio as the best way to keep bankers honest about their balance sheets. They have proposed forcing UK banks to make their ratios public by 2013 as a way of reassuring investors that banks have enough capital.
The Basel Committee on Banking Supervision, which sets global standards, agrees and has included a 3 per cent leverage ratio as part of its Basel III reform package. As envisioned, banks would have to reveal their leverage in 2015 and balance sheets would be capped at 33 times top quality capital by 2018.
But there is another side to this story. Capping total leverage has a disproportionate impact on banks that provide basic services to the wider economy, such as financing overseas trade. Because these are low-risk activities, they require very little capital under the RWA system, but under the leverage ratio they are treated exactly the same as high risk derivatives and speculative loans.
Bankers, industry groups, and some governments fear that imposing a leverage ratio could constrain such lending, halt global trade and damage the already fragile green shoots of recovery in the world economy. Cap leverage too low they say, and the tree won’t grow out of sapling stage.
French and German officials have led the charge against moving too far too fast on leverage, in part because their banks are expected to be hit particularly hard.
The issue has become live again this winter because the European parliament and council are debating the regulation that will apply the Basel package across the 27-nation bloc. Private French and German documents propose removing the requirement for banks to disclose their leverage levels by 2015 and further weakening may be in store. Trade finance providers, for example, are pushing for their activities to be exempted from the leverage ratio because they involve short-term loans with minuscule default rates.
Pushing against them are public interest groups such as Finance Watch, which recently suggested a moving leverage ratio – 5 per cent in good times, and 3 per cent in downturns – to encourage banks to be more cautious in booms while maintaining lending after a bust. They also want total assets to include all derivatives, rather than allowing banks to net off bets in opposite directions, a step that could force investment banks to shrink dramatically.
Finding a solution that curbs banker excess without choking growth will not be easy. There is a real temptation to create all sorts of exceptions for “good” lending. But policymakers should resist calls to add too many bells and whistles to what is supposed to be a straightforward “back of the envelope” calculation. In the end, it is the simplicity of the leverage ratio that gives it the power to shape banking into what society wants it to be.
.
Brooke Masters is the FT’s Chief Regulation Correspondent
In good times, leverage allows a tiny base to spread upward and outward like a tree, fostering growth and generating profits. In bad times, when asset prices fall rapidly, high leverage can leave a bank or hedge fund without enough cash and equity to withstand losses. In high winds, the tree risks being blown over.
In the years leading up to the financial crisis, bank balance sheets grew from 15 or 20 times their equity to 80 times at places such as Lehman Brothers. Expressed as a ratio of capital over assets, the equity base fell from 5 or 6 per cent to 1 per cent. In other words, the tree grew taller, spread and was more likely to tip over.
After the 2008 fiasco, regulators, determined to prevent a repetition, became convinced that a mandatory cap on leverage would make the system more stable. A leverage ratio not only limits overall borrowing by banks - linking the size of the tree to its root structure - but also addresses a dangerous weakness in the main measure of bank safety, the core tier one capital ratio.
Like leverage, capital is expressed as equity over assets, but the assets are weighted using complex internal models. In theory, banks have to hold more capital against risky trading and complex products than they need for safe lending to top rated borrowers. In reality, risk-weighted assets (RWAs) are vulnerable to regulatory arbitrage, such as when collateralised debt obligations were constructed to turn pools of risky loans into supposedly safe securities before the crisis. RWAs can also be affected by collective blindness, such the fact that all sovereign bonds have historically been considered risk-free with a zero weighting.
Some Bank of England officials, for example, see a leverage ratio as the best way to keep bankers honest about their balance sheets. They have proposed forcing UK banks to make their ratios public by 2013 as a way of reassuring investors that banks have enough capital.
The Basel Committee on Banking Supervision, which sets global standards, agrees and has included a 3 per cent leverage ratio as part of its Basel III reform package. As envisioned, banks would have to reveal their leverage in 2015 and balance sheets would be capped at 33 times top quality capital by 2018.
But there is another side to this story. Capping total leverage has a disproportionate impact on banks that provide basic services to the wider economy, such as financing overseas trade. Because these are low-risk activities, they require very little capital under the RWA system, but under the leverage ratio they are treated exactly the same as high risk derivatives and speculative loans.
Bankers, industry groups, and some governments fear that imposing a leverage ratio could constrain such lending, halt global trade and damage the already fragile green shoots of recovery in the world economy. Cap leverage too low they say, and the tree won’t grow out of sapling stage.
French and German officials have led the charge against moving too far too fast on leverage, in part because their banks are expected to be hit particularly hard.
The issue has become live again this winter because the European parliament and council are debating the regulation that will apply the Basel package across the 27-nation bloc. Private French and German documents propose removing the requirement for banks to disclose their leverage levels by 2015 and further weakening may be in store. Trade finance providers, for example, are pushing for their activities to be exempted from the leverage ratio because they involve short-term loans with minuscule default rates.
Pushing against them are public interest groups such as Finance Watch, which recently suggested a moving leverage ratio – 5 per cent in good times, and 3 per cent in downturns – to encourage banks to be more cautious in booms while maintaining lending after a bust. They also want total assets to include all derivatives, rather than allowing banks to net off bets in opposite directions, a step that could force investment banks to shrink dramatically.
Finding a solution that curbs banker excess without choking growth will not be easy. There is a real temptation to create all sorts of exceptions for “good” lending. But policymakers should resist calls to add too many bells and whistles to what is supposed to be a straightforward “back of the envelope” calculation. In the end, it is the simplicity of the leverage ratio that gives it the power to shape banking into what society wants it to be.
.
Brooke Masters is the FT’s Chief Regulation Correspondent
Copyright The Financial Times Limited 2012
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