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How should we supervise banks given that the financial system is inherently complex? I am convinced that in a complex world – first – supervisors need a toolbox with different instruments to cope with this complexity, and – second – those tools will not generally be that simple.
Bank equity is supposed to cover the first losses in the event of a default before the claims of debt holders, and potentially depositors, are affected. If we take a bank’s assets as given, more equity strengthens the debt holders’ position at default and makes the bank safer.
There are, however, two competing concepts. Ratios following the first concept take aspects of banks’ asset risk into account and divide capital by assets subject to some risk-weighting – the well-known Basel II Tier 1 capital ratio is a prominent example. By contrast, the second concept is risk-insensitive. The ratio is defined as capital over a non-risk based exposure measure, such as total bank assets. This is the world of the leverage ratio. I will attempt to test some of the advantages of the non-risk based leverage ratio – particularly its alleged simplicity – against reality.
1. Is it a simple, comprehensive and comparable measure?
The Basel Committee on Banking Supervision has been working on such a measure for about three years, without a final outcome. However, proponents of the leverage ratio may argue that its obvious definition would simply be the bank’s accounting equity divided by its total assets. Yet a leverage ratio defined in such a simple way has two major drawbacks: it is neither comparable as banks use different accounting standards nor is it comprehensive. This I would like to illustrate this by looking at three different aspects of the Basel III leverage ratio definition:
2. Is it an advantage to be insensitive towards risk?
A leverage ratio is risk-insensitive by definition but punishes low-risk business models, and it favours high-risk businesses, encouraging banks to engage in more risk-taking.
3. Moving away from risk-oriented banking regulation?
Introducing the leverage ratio as the primary regulatory requirement would mean taking two steps back to the risk-insensitivity of Basel I and even beyond. There is a danger that we will effectively end up with a leverage ratio only, because a sufficiently high leverage ratio requirement will override the calculation of risk-weighted assets.
What should we do instead?
My answer is straightforward: we should stick to the Basel III timeline. Under the Basel III timeline, banks will be required to disclose their leverage ratios as of 2015, which allows both the supervisors and the investors to use it as an indicator for bank risk. However, the definition will remain under review until 2018, when the decision about its introduction as a binding “Pillar 1” requirement will eventually be taken. I believe that we should use this parallel run period for further analyses regarding the leverage ratio’s interaction with risk-based capital requirements, regarding the undesirable incentives it may potentially create, and regarding its impact on low-risk business models.