Bank of England’s new chief Carney faces potential conflict of interest in shaping global leverage ratio

By:
Sid Verma
Published on:

The BoE governor-designate, in his capacity as Financial Stability Board chairman, is pushing for a sharper leverage ratio for banks but will encounter fierce resistance in the UK.


The unexpected appointment of Mark Carney as Bank of England (BoE) governor, effective in July, has set off fervent speculation over how his Canadian experience and role as Financial Stability Board (FSB) chairman at Basel will shape his UK banking responsibilities.

As Euromoney has reported, in an interview published in October, Carney indicated he was in favour of the universal banking model, buttressed by strong minimum capital-adequacy requirements, increased risk-weighting and value-at-risk modelling of trading books, as well as sound supervision.

The comments suggest Carney is comfortable with the UK government’s drive to enforce greater ring-fencing between the investment-banking and retail-banking divisions of banks rather than pushing for full separation of both operations.

Accordingly, Carney is likely to strike a constructive tone on the merits of the UK’s Vickers report and the EU’s Liikanen review, which seek to ensure monoline banking arms of a holding firm can be unwound in the event of a crisis, without imperiling depositors. Both reports recommend beefier loan-to-value limits for real-estate lending and better comparability of internal risk models between banks.

This UK and EU consensus on the structure of domestic banking systems should provide a rare source of comfort for Carney, who faces a daunting battle elsewhere: namely, the challenge of preserving the UK’s interests amid the EU banking union-drive, without being accustomed to the finer points of EU politics and legislative technicalities.

Mark Carney, Bank of Canada governor
Mark Carney, Bank of Canada governor
However, even if Carney strikes an EU-wide consensus on the favoured structure of regional banking systems and successfully coordinates the UK’s regulatory push with European authorities, Carney faces a substantial domestic challenge. Namely, he has to balance the Basel push for a disruptive leverage ratio for G20 banks with his UK banking responsibilities, amid fierce domestic resistance to a higher leverage benchmark.

From the point of view of the governor-designate, it will be an important battle to fight. From Carney’s Canadian and Basel perspective, the global financial crisis has underscored the allure of imposing a high leverage ratio for banks, a non-risk based prudential tool to complement minimum capital adequacy requirements. Although the Bank of Canada is responsible only for the conduct of monetary policy, with banking supervision under the purview of the independent agency of the ministry of finance, Carney is well aware of the systemic benefits of a high leverage quota.

Key factors that account for the stability of the Canadian banking system include a culture of risk aversion, sound supervision, conservative lending practices – and, crucially, a punitive leverage ratio. On the latter point, Canadian banks are governed by a maximum 20-times assets-to-capital multiple, which is a more comprehensive leverage ratio because it also measures economic leverage, to some extent, including specified off-balance-sheet items, divided by the sum of a given bank’s adjusted net tier 1 and tier II capital.

By contrast, UK banks have much more room for manoeuvre. In a surprising announcement, the UK government’s recent white paper, in response to the Independent Commission on Banking (ICB), led by Sir John Vickers, decided to apply the current international Basel leverage ratio target of 3%, rather than the ICB-recommended 4.06% ratio.

This move was described by one bank analyst as “a real surprise – and an indication of strong UK bank-lobbying behind the scenes”. European banking analyst Miguel Angel Hernandez at Barclays Capital attributes the 3% target as “a bid to put UK banks at a more a competitive position, in relation to international counterparts”, while boosting credit supply at a time of weak economic growth.

Lobby for leverage

The UK government’s move to opt for a 3% minimum ratio “implies that the leverage ratio, as it stands today, will be a secondary, rather than primary, capital constraint on the UK banks,” said analysts at Citi in a mid-September research note, adding: “We would not be surprised if this mindset eventually changes.”

Indeed. On the issue of the leverage ratio, Carney is likely to form an alliance with Andy Haldane, responsible for financial stability at the BoE. As Euromoney has reported, Haldane’s views on removing risk-weighing from the calculation of banks’ capital have earned a rebuke from Carney but they both agree on the efficacy of strong leverage ratios.

Haldane, in recent speeches, has favoured strong nominal capital measures, with a leverage ratio of 7% and above, as a backstop against bank failures. As this chart from Citi lays bare, using Haldane’s data, the “pre-crisis leverage ratio of ‘failing’ banks was statistically significantly lower than that of ‘surviving’ banks at a 1% significance level,” say the Citi analysts. By contrast, “the same cannot be said of risk-based capital ratios, which were not statistically significantly different between ‘failing’ and ‘surviving’ global banks”.



(Nevertheless, enforcing a leverage ratio, without risk-weighting, is a flawed approach, since it gives banks an incentive to load up on risky, high-returning assets to reduce their loss-absorbing capital requirements, reckons Carney.)

The current Basel and UK minimum is for a 3% ratio but, in practice, most UK banks run higher leverage ratios, in response to investors’ demand for higher loss-absorbing capital than the regulatory minimum.

However, the battle is now on. The Basel Committee is looking to impose a binding requirement by 2018, though it’s unclear whether even this lengthy time-line will be met, given the US decision to postpone the January 2013 initial Basel III start-date.

Most controversially, the Basel leverage-ratio proposal includes on-balance-sheet and off-balance-sheet exposures, a game-changer for US and UK banks’ capital requirements, in particular, given the size of their derivatives items and international trade finance lines.

As Euromoney has reported, banks are lobbying against any punitive inclusion of off-balance-sheet contingent liabilities essential for trade financing, such as guarantees for performance bonds in project financing and standby letters of credit. The Basel proposal would disproportionately hit trade-orientated UK banks, such as HSBC and Standard Chartered, says Hank Calenti, head of UK bank credit research at Société Générale.

Analysts at Citi speculate that a leverage ratio of around 5% to 6%, based on adjusted assets, netted for derivates and excluding liquidity reserves, would reduce systemic risk without imperiling banks’ capital positions. However, they concede such a move would prove controversial, and most likely to be enacted if the EU followed suit.

Nevertheless, a compromise could be found, said the Citi analysts. “A potential quid pro quo could then be that the Basel III core tier 1 ratio target is reduced to c8% to 9%. This would be more consistent with global standards than the 10% currently being pursued by the UK authorities, and would also make sure that the leverage ratio becomes a primary policy tool alongside risk-weighted metrics, rather than a redundant measure of capital strength.”

The jury is out on how much UK political capital Carney will have, or seek to deploy, in any fight for a higher leverage ratio, particularly given the government’s rejection of the ICB leverage recommendation.

The former Goldman banker has juggled his role as a global bank-reform aficionado with his Canadian interests – namely stating the Volcker rule is impractical and could put non-US sovereign bond markets at a competitive disadvantage. However, in the battle to shape the leverage ratio, Carney’s UK and FSB roles will prove a tough balancing act.