Banks’ leverage ratios: if only Premium

Holding more capital is no guarantee of safety – but will restrict flow of credit

As regulators work their way through the mess of the banking crisis, it is hardly surprising that many hanker after simpler times when a loan was a loan and equity was equity.

A desire for simplicity is perhaps one of the reasons UK legislators have picked a fight with the government over leverage ratios, the basic measure of a bank’s equity as a proportion of total assets.

In a report on Monday they take issue with the government’s decision to stick with the 3 per cent minimum required by Basel III, and want UK banks to be subject to a higher requirement. They also dismiss the use of ratios based on risk-weighted assets as “the fraying threads of the capital ratio safety net”.

There are several problems with the legislators’ approach, not least the insistence on higher levels of capital. Holding slightly more capital might save a bank in a crisis, but there is no guarantee of that. What is easier to predict is that bigger capital requirements will, at least in the short term, restrict the flow of credit into the economy.

The leverage ratio itself is also far from a perfect measure of banking safety. Used in isolation, it forces banks to hold proportionately the same amount of capital regardless of the riskiness of their loan books, and so is an incentive for them to seek out riskier assets that offer higher returns.

Nor is it as straightforward as its supporters suggest. The treatment of derivatives can make a big difference. Barclays analysis this year showed that the leverage ratio for UBS ranged from 6.6 per cent to 1.7 per cent depending on the definitions used.

At best, the total leverage ratio is useful as a support for more subtle measurements of capital as a proportion of risk-weighted assets. Here, one of the UK legislators’ other suggestions has merit. Annual published assessments of risk weightings by the Bank of England would increase public confidence in the risk-weighted assets system and perhaps prevent a slide back to the view that simpler ratios are necessarily better.

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