Leverage ratios: method in the madness

By:
Sid Verma
Published on:

The rationale for a higher benchmark is clear but regulators must clarify its role, alongside a risk-based capital regime, to reduce distortions and save the securities-financing market from a liquidity crisis.

There is a rhythm to regulatory announcements: unveil new standards seemingly on a daily basis, abruptly reshape an established rule, leave questions on forbearance unanswered and then shift the capital goalposts further out of banks’ reach, whenever they eye dividend targets. 

Still, there is method in the madness.

Regulators are “caught in an arms race of competitive re-regulation”, as one bank analyst puts it, reversing the tide of deregulation between the late 1990s and 2007. After the latest slew of international initiatives – greater loss-absorbing debt capital, charges in banks’ trading books and more punitive risk-weighting of assets – regulators are now finally focusing on a higher leverage ratio, which is potentially the least market-distorting way to boost banks’ capital buffers and reduce the risk of another systemic crisis. 

This week, UK chancellor George Osborne accepted that the UK might need to set a higher baseline ratio, especially for ring-fenced banking groups, but placed the onus on the Financial Policy Committee at the Bank of England (BoE) to demonstrate how higher equity thresholds adopted before the 2018 Basel deadline would boost financial stability. This should be seen as a victory for BoE governor Mark Carney, who has been gunning for a more ambitious calibration of the leverage rule after the government last year unexpectedly rejected the Independent Commission on Banking’s recommendation for a 4.06% ratio and instead backed the 3% Basel minimum.

The rationale for a higher benchmark is clear but regulators must clarify its role, alongside a risk-based capital regime, to reduce distortions and save the securities-financing market from a liquidity crisis. According to the BoE’s own analysis, more punitive leverage ratios, rather than risk-based capital regimes, would have prevented the global banking crisis. Even former Fed chair Alan Greenspan thinks the leverage ratio should be 10% or higher, rather than the 6% proposal in the US.

By contrast, the equity thresholds of global capital-market-orientated banks, UK and European lenders, in particular, remain a source of systemic risk, with the leverage ratio at Barclays, for example, at just 2.5%, as of the third quarter of 2013, according to SNL Financial. Nevertheless, leverage ratios should be seen as a backstop to existing risk-based capital rules rather than the principal binding restraint on banks’ equity thresholds, to ensure institutions don’t have a regulatory incentive to gobble up higher risk, and less liquid, assets to generate higher returns – at odds with the liquidity coverage ratio.

What’s more, without regulatory redress, there is a risk of a liquidity crisis in the government cash bond market and in securities financing, especially if cash is included in a bank’s calculation of total assets. In any case, the recent focus on the leverage ratio confirms the de facto regulatory cap on cash to shareholders by the larger banks won’t end anytime soon – and neither will the bank-deleveraging cycle.