A worrying wobble: Bank regulators should not have weakened rules that limit leverage

A worrying wobble: Bank regulators should not have weakened rules that limit leverage

Jan 18th 2014 | From the print edition

IN THE immediate aftermath of the financial crisis, politicians and regulators from around the world stood shoulder to shoulder and promised to tame the excesses in the banking system that had brought the global economy to its knees. Among the first of their proposed reforms was to have more loss-absorbing capital in banks to reduce the risks of future taxpayer-funded bail-outs. How quickly memories fade.On January 12th the Basel committee, a club of central bankers and supervisors, released new rules that are weaker than their previous proposals (see article). The technical tweaks may let big banks—mostly European ones—off the hook of having to raise as much as €70 billion ($96 billion) in capital. Although banks will still have to meet a leverage target of at least 3%, the formula for calculating it has been softened. The next day brought a surge in the share prices of big banks, which had lobbied hard for a dilution of the rules. Investors’ elation ought to be worrying for taxpayers.

One of the most remarkable features of the financial crisis of 2008 was the razor-thin capitalisation of many of the world’s largest banks. In theory, the banking system had entered the crisis with comfortably thick cushions. New rules known as Basel 2 had insisted that banks have minimum capital ratios of 8%. When the crunch came, however, the actual loss-absorbing capital available to many big banks was less than 2% of their total assets. In other words, they could run up losses of no more than $2 for every $100 invested without going bust, instead of the $8 the regulators had presumed.

Remembering nothing

The startling discrepancy was largely a result of “risk-weighting” of banks’ assets: the idea was to reward cautious banks with more creditworthy borrowers by allowing them to have less capital than their more daredevil peers. Yet risk-weighting proved dangerously flawed. Banks suffered losses on supposedly safe assets, whether souped-up bundles of subprime mortgages or Greek government bonds. The complexity of the risk-weighting methodology also let banks run rings around their regulators. An important lesson of the crisis was thus to back up the rules based on risk-weighted assets with a simple and easily verified limit on leverage.

The “leverage ratio”—the ratio of equity to assets—is certainly a crude measure. Critics point out that it treats a home mortgage with a big slug of equity in the property no differently from an unsecured credit-card balance owed by a spendthrift student. European banks, which keep most of the mortgages they issue on their balance-sheets and also risk-weight their assets energetically, would be especially hard hit compared with American banks, which offload their mortgages to capital markets with the help of government-backed agencies such as Fannie Mae and Freddie Mac. Only a quarter of Europe’s big banks would have met the previously proposed limits without raising capital (or reducing assets), compared with three-quarters of American banks. Tighten leverage standards now, European banks complain, and the flow of credit to the economy will be choked off, harming an incipient recovery.

But this misdiagnoses the problem. The weakness of Europe’s banks does not stem from having to raise too much capital. They have simply failed to clean up their balance-sheets in the way their American peers were forced to do by regulators. They remain so thinly capitalised that they are unwilling to write down dud loans and take on the risk of new ones—hence Europe’s credit crunch. If Europe’s banks met the leverage ratio, investors would trust them more. They could then finance themselves in capital markets and wean themselves off the support of the European Central Bank.

A tough leverage ratio is no panacea. Nor is it a substitute for risk-weights used in the main capital calculations under the Basel rules. But it provides a robust guardrail to constrain risk-taking. Regulators were wrong to weaken it: they should resist the bank lobby and revert to their previous plans.