Why the Bank Leverage Ratio Is Important

Mayra Rodríguez Valladares is managing principal at MRV Associates, a New York-based capital markets and financial regulatory consulting and training firm. She is also a faculty member at Financial Markets World.

In speaking about the leverage ratio, an extremely important bank capital requirement, Thomas Hoenig,vice chairman of the Federal Deposit Insurance Corporation, said: “I think we’ve got the details worked out. Now it’s just getting the schedule.”

His comments on Monday at a National Association for Business Economics conference are the biggest hint that United States banking regulators have finalized and will soon announce a proposed leverage ratio for banks that was released for comment last July.

The Federal Deposit Insurance Corporation has proposed the ratio at 5 percent for bank holding companies and 6 percent for insured bank depositories, Most important, only high quality capital such as common equity and retained earnings would count for the numerator.

While the United States has long had a leverage ratio of 4 percent, the denominator covered only on-balance sheet assets; the new leverage ratio’s denominator would cover all assets and off-balance sheet transactions such as derivatives. For banks like JPMorgan Chase, which have about $2 trillion in assets but $70 trillion in notional amount of off-balance sheet derivatives, the impact of the new leverage ratio will be significant.

Given that American banks tend to be extremely leveraged, and certainly far more than non-financial companies, financial lobbying groups have fought passionately against the leverage ratio. Like other financial reform advocates, I have long awaited the leverage ratio. It is extremely important, because it could serve as a backstop for the existing Basel III risk-weighted asset capital framework that presently exists.

In calculating risk-weighted assets, banks that meet a significant number of requirements can receive permission from their bank regulator to use what is called an advanced international ratings-based approach. This method allows banks to use their own data and models to determine risk factors like probability of default of assets or counterparties and extent of loss severity when there is a default. Risk-weighted assets are an extremely important component of how capital requirements are determined for banks.

As I have seen in over a decade of working with banks and regulators globally, allowing banks to use their own models to derive the risk inputs, leads to great flexibility in these risk-weighted assets. The Basel Committee on Banking Supervision’s own studies last year proved that there is tremendous variability in the risk weighted assets of United States, European and Asian banks even when banks have similar portfolios.

Not only is there no transparency in how banks come up with their risk inputs, worse yet, this variability, or what many fear might be data manipulation, means that banks end up with very different levels of capital, which may or may not be sufficient to help them sustain unexpected losses.

The leverage ratio is also important, because like the Volcker Rule, if supervised and enforced stringently, it can influence banks to sell riskier assets and off-balance sheet items, making them smaller. The main reason that the F.D.I.C. has taken the lead on the leverage ratio is because now under Dodd-Frank, if a large, internationally active bank were about to fail, the F.D.I.C. is charged with the responsibility of putting that bank through the newly established Orderly Liquidation Authority mechanism and helping its resolution.

While the F.D.I.C. is extremely experienced in resolving insolvent banks, it has never resolved a bank larger than Continental Illinois National Bank and Trust Company, which declared bankruptcy in 1984. That bank’s resolution remains the largest in American history. Unlike today’s banks, many which are over $250 billion in assets across hundreds of different domestic and foreign entities, Continental Illinois was mostly a domestic bank of about $40 billion in assets.

The proposed F.D.I.C. leverage is higher than the 3 percent that the Basel Committee recently finalized for its 27 country members. With the Basel announcement immediately came cries from banking lobbies that the higher proposed leverage ratio in the United States would put them at a competitive disadvantage.

Given the significant weakness of most European banks and the fact that even large banks from emerging banks are still a small presence in the United States, this oft repeated competitive disadvantage argument should not derail efforts to improve banks’ low, capital levels. Main Street continues to feel that what really puts the United States at a competitive disadvantage are the detrimental and far reaching effects of bank influenced, if not induced, boom and bust cycles.

It is high time that we lead globally by example in having a healthier banking sector.