Banks jolted as regulators seek to crack down on leverage

Banks jolted as regulators seek to crack down on leverage

10:21am EDT

By Steve Slater

LONDON (Reuters) – New demands from regulators to force banks to keep a lid on risk-taking after the financial crisis has re-ignited a debate over how best to strengthen the industry without stifling lending or alienating investors.

Bank regulators in the United States this week set out plans to impose a leverage ratio on banks that caps their lending based on a simple assessment of their equity. Britain and Switzerland have also demanded their banks “gold-plate” a global rule for this leverage cap or ratio.Until now, regulators had focused mainly on getting banks to hold more capital and liquidity to prevent a repeat of the taxpayer bailouts of the industry during the 2007/2009 crisis.

Now excessive leverage is their sights because the capital rules rely on banks’ own assessments of the riskiness of their lending. And regulators are worried that banks may be gaming the system.

“The leverage ratio has come up the pecking order and could now be a big constraint on the banks,” said Chris Wheeler, analyst at Mediobanca in London. “Inevitably it was going to be the next shoe to drop, and the question is how far it is pushed by the regulators.”

Supporters of the leverage rules say it is a welcome return to a simple a measure, which is harder for banks to manipulate.

Critics say the leverage ratio is too blunt a measure of danger and should be just a backstop to more complex risk-based capital requirements.

Deutsche Bank finance chief Stefan Krause said the leverage ratio was too simplistic. “We can’t call for a return to horse-drawn carriages every time an automobile component doesn’t function properly,” he said in an interview with German newspaper Boersen-Zeitung.

Analysts reckon most banks should be able to meet the new leverage rules without having to turn to investors for more cash, something many banks have done to meet the capital regime.

But they may take steps to reduce the impact, and could shrink the liquidity buffers they have been encouraged to build up, shift assets to other parts of their group, shorten the duration of derivatives contracts or cut repo activity.

They could also pull back in government bond trading, as high volume, low-risk and low-margin businesses become more costly. Or they could simply cut back on lending.

Regulators say banks hit by the leverage requirements have other options: cut or delay dividends or reduce pay for staff.

“Leverage is clearly a major issue for banks’ investors – credit and equity,” Huw van Steenis, analyst at Morgan Stanley, said in a note. “For a number of EU banks the leverage ratio will increasingly become the governing constraint.”

EUROPE HIT HARDEST

The Bank of England has told Barclays (BARC.L: Quote, Profile, Research, Stock Buzz) and mutual mortgage lender Nationwide, the only British banks to grow lending in the first quarter, they are not allowed to cut lending to meet the leverage ratio goal.

The Bank defended its sudden introduction of a leverage target as an extra lever because some banks had shown “quite a bit of slippage” on their plans to strengthen capital.

“I am not a one club man,” said Andrew Bailey, its head of banking regulation, referring to the need for a dual approach.

Europe’s banks are seen as the most heavily impacted by the tougher rules, as they have been slower to build up capital.

The leverage ratio measures the amount of equity (capital) a bank holds as a percentage of its assets (loans), without adjustments for risk.

Deutsche Bank has a leverage ratio of 2.1 percent, UBS (UBSN.VX: Quote, Profile, Research, Stock Buzz) and Credit Suisse (CSGN.VX: Quote, Profile, Research, Stock Buzz) stand at about 2.2 percent (excluding contingent capital) and Barclays (BARC.L: Quote, Profile, Research, Stock Buzz) is at 2.8 percent, compared to an average of 3.7-4 percent at the big U.S. banks, according to analysts at Morgan Stanley.

The proposals could leave Deutsche Bank’s U.S. subsidiary with a capital shortfall of 17 billion euros ($22.17 billion), analysts at Espirito Santo estimated.

But differences around methodologies and timing make it hard to gauge how close banks are to meeting the targets. It is also tough to predict how much they will need to do to get there.

Barclays, for example, could need 7 billion pounds of extra capital to meet UK demands. But using Canada’s leverage regime, its ratio would be as strong as Canada’s major banks, considered some of the safest in the world, Morgan Stanley estimated.

Deutsche Bank’s needs may hinge on the main unresolved issue of whether leverage calculates derivatives holdings on a “netted” or gross basis. U.S. accounting rules allow for calculations of net positions but international standards require gross positions, which can be much larger.

At Deutsche, it could be the difference between having 2 trillion euros in assets or 1.2 trillion, which has a huge impact on the ratio. Deutsche pointed to Krause’s comments when asked about its views on the ratio impact.

At a global level, regulators are attempting to harmonize the rules. But bankers and analysts do not expect clarity any time soon. “The real challenge is going to be to get some consistency,” Mediobanca’s Wheeler said.