ByJoseph Mason

Derided by the industry as recently as last year as largely irrelevant due to its simplicity, that same simplicity is the cause of its recent popularity in a world of models gone awry.

US Basel II implementation, which sought to do away with the leverage ratio, has always been contentious. Amid concerns that small or large banks would be advantaged by either the standardized or risk-based approaches, respectively, there was substantial concern that the framework would be obviated by prompt corrective action provisions and leverage ratio restrictions enacted as part of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). The idea was that, even prior to even Basel I implementation, a bank with capital in excess of 5% of assets – that is, with a leverage ratio of over 5% – was likely to have a reasonable amount of capital in relation to expected losses. Under FDICIA, regulators must take specific actions – called prompt corrective actions (PCA) – when a bank’s leverage ratio falls below 5%. If those prompt corrective actions are insufficient to save the bank, a receiver must be appointed when the leverage ratio falls to 2 percent or lower.

Previous complaints about the leverage ratio were threefold. First, the 2% prompt corrective action threshold was arbitrary and based on book value, so that a bank could be considerably undercapitalized on a market value basis without being closed, or vice versa. Second, the leverage ratio does not account for underlying asset risks at the bank, which led to such consideration for Basel I, and now Basel II risk-based capital ratio implementation. But as Basel focused on risk-based assets, banks almost immediately sought to simply remove assets from their balance sheets. Banks therefore took direct advantage of the third shortcoming of the leverage ratio – it doesn’t take into account off-balance sheet activities. Off-balance sheet activities such as securitization reduced the denominator of the ratio. Commensurately, hedging loan credit risk with credit default swaps reduced the appearance of risk with off-balance sheet commitments. Incentives to arbitrage the more complex arrangements therefore led securitization and credit default swaps to be two of the fastest growing financial industry sectors over the past several decades, and created the present credit crisis.

The industry used the shortcomings to argue that the leverage ratio should be abandoned. The industry advocated such changes as late as February 2007, upon the release of a GAO study on Basel II implementation. At that time, Steven Sloan of the American Banker wrote, “The GAO … stopped short of calling on regulators to abandon the leverage ratio,” but noted that industry representatives would still like to see the change. (“A Green Light, And a Yellow, For Basel II,” American Banker, February 16, 2007, Steven Sloan)

During that period, the FDIC carried the flag for the leverage ratio, sometimes seemingly by itself. In the GAO report, the FDIC noted, “regulators share a commitment to maintaining a safe and sound banking industry and that retention of the existing leverage ratio and prompt corrective action framework, and other safeguards in the NPR, underscore that commitment.” (“Bank Regulators Need to Improve Transparency and Overcome Impediments to Finalizing the Proposed Basel II Framework,” GAO-07-253 Risk-Based Capital, February 2007, p. 80)

Now, the tables seem to be turning. On June 19, 2008, Peter Thal Larsen of the Financial Times reported that, “Philipp Hildebrand, vice-chairman of the Swiss National Bank, called for the introduction of a “leverage ratio”, which would place a limit on the extent to which a bank’s assets could exceed its capital base.” (“Swiss banker calls for ‘leverage ratio’”, Peter Thal Larsen, June 19 2008) The idea now is that while adjusting the leverage ratio for risk is a laudable goal, the models that facilitate the adjustment are necessarily flawed to one extent or another and cannot be adequately relied upon, in isolation.

Hence, there is hope that bank regulators are beginning to learn the first lesson of risk management – never rely on any single measure of risk. Hopefully they will soon learn the second –substantial deviations among risk measures may be a flag of something seriously wrong. I seriously doubt, however, that they are ready for the third – there is nothing wrong with looking at a “managed” leverage ratio, including all the assets that are purportedly sold in securitizations and the risk that has been “hedged” with illiquid credit default swaps that expose them to substantial counterparty risk.