Wednesday, July 10, 2013

The 5% Leverage Ratio

Well, I'm not sure a 5 percent leverage ratio shouldn't really qualify as tightening the screws, but apparently some think it's too strict.

FDIC to Tighten Screws on Banks, Require 5% Leverage

It's a tougher standard, yes, but requiring a 5 percent leverage ratio for the bigger banks seems hardly unreasonable considering the implications of a larger one getting into trouble. The 5% leverage rule does seem far more adequate than the 3 percent leverage ratio proposed under Basel III.

In fact, it seems easy to argue it should be even higher.

From this CNBC article:

The asset number includes off-balance-sheet items and will not be adjusted for riskiness. The proposed rule for so-called "simple leverage" is 2 percent higher than the minimum simple leverage rule under Basel III.

This simply means that larger bank holding companies (BHCs) will need to have capital that's at least 5 percent of its assets -- including the adequate capture of what's off-balance sheet -- compared to the 3 percent under Basel III.*

Again, seems more than fair. Also, the sheer simplicity of this rule likely makes it more difficult to game than some of the other capital rules that are based upon risk-weighting. To an extent a banker has the latitude to set the appropriate risk-weights. Well, there's just too much room for subjectivity in that kind of system.
(The simple leverage ratio relies much less on these kind of subjective judgments though, of course, no one measure is ever going to be perfect or, for that matter, even adequate by itself.)

More from the article:

By piling off-balance-sheet items into the ratio, the regulators have made banks' capital burdens much heavier.

Even if this were to cause some near-term challenges for certain banks, the long run overall benefits would appear to be more than worth the headache it causes. Fed Governor Daniel Tarullo said the following about the Basel III leverage ratio:

"Despite its innovativeness in taking account of off-balance-sheet assets, the Basel III leverage ratio seems to have been set too low to be an effective counterpart to the combination of risk-weighted capital measures that have been agreed internationally."

The 3 percent level does seem rather insufficient to absorb losses that could occur during a serious financial crisis. That doesn't mean the Basel III leverage framework isn't useful; it just means that 3 percent is too low. If set at an appropriately higher level -- necessarily a judgment call though I'll take a slight bias in favor of a stricter rule -- something like the Basel III leverage framework (or something similar) appears to have advantages over some of the other capital requirements.

Not only does it attempt to capture what's off-balance sheet, the Basel Committee on Banking Supervision thinks that this kind of leverage ratio will be more transparent than the other capital requirements.

Basel Proposes 3 Percent Bank Debt Ratio

From this CFO Magazine article: would be more transparent than other capital requirements, because banks would have to disclose the information in a common format.

Banking, at its best, is a vital utility. No standard is going to work perfectly but a high enough leverage ratio just might just help to protect against the inevitable excesses that occur from time to time. More from the article:

A simple leverage ratio would force financial institutions to hold the same amount of quality capital against any loan they make, regardless of the riskiness of the loan. That contrasts with other capital ratios that assign a "risk weighting" to loans to require a larger capital cushion for riskier instruments.

The quality bank can still make a nice return for investors at this kind of leverage ratio (and likely even a much higher standard for leverage).

Charlie Munger weighed in on bankers during this CNBC interview in early May:

"A banker who is allowed to borrow money at X and loan it out at X plus Y will just go crazy and do too much of it if the civilization doesn't have rules that prevent it."

And later...

"I do not think you can trust bankers to control themselves. They are like heroin addicts."

The system should be built to encourage more safe and sound traditional banking activities and less of the exotic stuff. Much financial innovation ultimately boils down to some clever way to increase leverage (both on and off-balance sheet) in ways that's not always transparent until it's too late.

"All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets." - John Kenneth Galbraith in the book: A Short History of Financial Euphoria (Page 19)

It's not just less leverage and more transparency that's needed.

It's stable funding sources so financial institutions are more resilient and less likely to become liquidity challenged during the tough times.**

It's less speculation and what is, effectively, even pure gambling.

It's reduced emphasis on facilitating short-term bets of various kinds and a greater emphasis on long-term outcomes.

It's less complexity; fewer derivatives.

More real accountability and financial pain for those in charge if things happen to go very wrong. This necessarily requires wise changes to the prevailing compensation systems for key individuals.

Even small step in the right direction are welcome but, realistically, a good chunk of what's really needed is unlikely to be implemented quickly if at all.

No matter what, the system will always depend on bankers who know how to effectively manage risk with enough skin in the game and integrity to care about doing the job well. Money that's government guaranteed -- the FDIC insured deposits of clients, for example -- or, more generally, other people's money, shouldn't be funding the riskiest activities without some wise limits in place.

The world needs a banking system that's less involved in speculative zero-sum "casino" bets (including things like proprietary trading), and puts more into competently getting funds to good ideas and productive activities.

An emphasis on stability, intelligent risk management, effective capital formation and allocation, while getting as many of the other frictional costs out of the system as possible. For lots of reasons much of what would improve the system isn't happening anytime soon. That reality doesn't make it any less worthwhile to understand what changes make sense.

We'll see if real progress -- even if inevitably less than perfect -- continues to be made.

Reign in the excesses and get back to an emphasis on traditional banking: Reliably taking in deposits, lending those funds intelligently, and providing related services. Within investment banking, dial way back the casino-like activities. Instead, they ought to be primarily about capably raising capital -- at an appropriate cost considering the specific risks -- and so it efficiently gets in the hands of those who can put it to good use.

These things can be a great advantage to any economy if consistently done well over the long haul.

Banking might justifiably be viewed cynically by many considering recent behavior and the consequences of  that behavior.

Yet, with better system design and some wise limitations in place, banking can better play its vital role and become much more trusted.


Basically, it appears they'd like to see a 5 percent leverage ratio for the larger BHCs, and a 6 percent ratio for any insured depository institution that's a subsidiary of these larger BHCs. The Office of the Comptroller of the Currency (OCC), Federal Deposit Insurance Corporation (FDIC), and the Federal Reserve Board (FRB) yesterday proposed doubling the leverage ratio on an insured depository institution owned by a BHC. So these "agencies are proposing to establish a 'well capitalized' threshold of 6 percent for the supplementary leverage ratio for any insured depository institution that is a subsidiary of a covered BHC..."

In addition, they are also proposing that "a covered bank holding company would be subject to a supplementary leverage ratio buffer of 2 percent, above the 3 percent minimum requirement for banking organizations using the advanced approaches under the new capital rule."

Raising the leverage ratio isn't enough. What ends up in the numerator and the denominator matters. The updated Basel III guidelines make significant changes to the denominator -- a bank's exposure. Leverage requirements that only take into account on-balance sheet assets make a bank appear better capitalized than it is. Some banks have derivatives that are significant compared to what's on their balance sheet.

The new leverage has to capture two important types of exposure related to derivatives. With derivatives, it's not only the exposure arising from the underlying reference asset that matters, it's also the credit risks of the counterparty.

The proposed guidelines require that the entire contingency liability related to a derivative be in the leverage ratio's denominator. With this requirement in place a bank seems more likely to be better capitalized and able to absorb an unexpected loss.

The new guidelines also require banks to disclose publicly the different components included in the leverage ratio. For any leverage ratio, a bank is going try and increase what's allowed in the numerator and try to get as little as possible included in the denominator. Disclosure makes all the difference if it is to be trusted.

The recommendation that U.S. bank holding companies have a ratio of 5% and that insured depository subsidiaries have a 6% ratio sounds good versus the 3%, but it comes down to what's required in the new measure. If it is based on the 2010 framework instead of something closer to the updated framework then it's a vastly weaker measure. In any case, the lobbying will no doubt continue.
** I'm speaking of the liquidity within leveraged financial institutions themselves so the system is more resilient and remains stable when under stress. In other words, more liquidity in capital markets to facilitate the hyperactive trading of marketable securities isn't needed, but what are fundamentally and necessarily rather leveraged financial institutions must be set up so the system overall can remain stable when certain short-term funding sources become less viable. If anything the world would surely be better a place with much less rapid fire trading in markets justified under the guise of liquidity benefits.

"It's a myth that once you've got some capital market, economic considerations demand that it has to be as fast and efficient as a casino. It doesn't." - Charlie Munger at UC Santa Barbara in 2003

Capital markets would be more useful and effective if a greater proportion of participants were encouraged to be long-term owners instead of being short-term renters of different kinds. Currently, the system appears built mostly for participants to make bets on price action and less for participants to invest with long-term effects -- increases to per share intrinsic value -- primarily in mind. That's too much of an internal focus. It should be designed, instead, with a focus on effective capital formation, wise allocation, and long-term outcomes in the real economy beyond the capital markets. It shouldn't be designed to mostly serve highly active participants who are there to profit from price action -- and maybe even profit from fee generation in different forms -- but are often otherwise least interested in the real external economic impact. With better system design, the various frictional costs in the current system would become much reduced and it would better serve its external purpose. There will always be a place for speculation, as well as the various forms of fee generation, in capital markets but the proportion does matter.
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