If an innocent but curious investor wished to understand the leverage ratio, they can find an easy definition on Investopedia. It’s just assets divided by equity, a simple heuristic whose elemental beauty has seduced regulators for years.
Unfortunately, the regulatory leverage ratio is considerably more complicated, thanks in part to the lobbying of the financial industry, wrangling in forums supposed to promote international co-operation, and the inherent complexities of valuing long term assets at a single point in time.
Now, US authorities may make it more complicated still, with proposals last month from the US Treasury to exempt cash, US Treasury bonds, and initial margin for derivatives trades from the calculations.
That’s alongside the other exemptions already agreed at a Basel committee level — some netting of derivatives, central clearing, margin received in cash and so on.
Derivatives aren’t always accurately reflected in accounting balance sheets, so it was never going to be a straightforward case of adding up accounting assets and shareholders equity, but it’s striking that the “regulatory” leverage ratio almost always looks better than the pure accounting measure.
There are different numerators as well — Basel’s leverage ratio uses tier one capital (equity as well as additional tier one), though it also tracks a total capital and a common equity tier one ratio. The US “Supplementary Leverage Ratio” is rather more purist about its definition of capital, but folds in other levels of confusion.
The 6% minimum it appears to prescribe is not, actually, a minimum requirement – instead, it is a minimum to signal to regulators that a large bank subsidiary with ensured deposits is adequately capitalised. Falling below 6% might stop capital distribution and trigger a wrist slapping from regulators but it isn’t actually the required floor. Different minimum levels apply for smaller institutions, or banks without insured deposits, or bank holding companies.
In short, leverage ratios are anything but simple, and that means their intended purpose is becoming diluted. There is already a highly sophisticated, globally agreed (more or less) regulatory framework based on risk-based capital. The Basel Committee has toughened up its “standardised approach” to calculating risk-based capital and the internal models-based approach used by most large banks.
It’s far from perfect, but, with a few add-ins, it accounts for pretty much every kind of asset risk a bank could experience. Mortgage banks can present their mortgage models, their historical data and their mortgage management techniques to their supervisors; trading banks can trumpet their market risk controls, and the whole system tries, as far as possible, to be neutral between different bank business models.
In case it fails, though, there is a leverage ratio. A highly complex system like risk-based capital could be vulnerable to being gamed, and, given the greater resources available to banks, a prudent regulator shouldn’t expect to catch every trick they try.
Instead, you have a simple backstop measure: add up all the assets and the equity, and if it looks wrong, then it probably is.
But if every country starts to tweak the backstop to suit its purposes, then it will no longer work properly as a backstop. The US has judged that US Treasuries are risk-free for its purposes and its investment banks should be encouraged to continue trading them and running matched-book repo desks.
If the US can do this, then why shouldn’t the BaFin decide that Bunds are similarly risk-free, and if them, why not Pfandbriefe as well? Why, though, should the Germans do this if the Italians must add BTPs to their leverage ratio calculations? Cash, too, is much harder than it appears. Dollars can settle nearly anything a bank might wish to settle, but Zambian kwacha has a far smaller audience. The Bank of Zambia, though, can doubtless come up with plenty of reasons to carve out its currency from local financial balance sheets.
US regulators, overseeing the world’s reserve currency, can get away with throwing their weight around in a way that the Bank of Zambia cannot, but a global backstop has real utility. Comparing bank leverage ratios is a crucial check on the far more complex risk-based ratios. If each country goes its own way, this limit disappears — and so does any attempt at regulatory harmony.