Dusting off an antique ratio to save the world

Regulators are hoping the 'leverage ratio' will iron out global discrepancies between banks' capital requirements and provide an adequate buffer against a financial crisis.

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When Anshu Jain finally buckled in April and agreed to raise €3 billion of new Deutsche shares, he was rewarded with a surge in the stock price.

The market took heart that the bank was now one of the best capitalised of its peer group, instead of one of the worst. Burnished with new equity, Deutsche even leapfrogged JPMorgan Chase, which has long boasted of a “fortress balance sheet”.

But the victory of Jain, co-chief executive of Germany’s largest lender, was short-lived. Within weeks it became clear that Deutsche’s capital raising had been overtaken by a new regulatory agenda.

Officials were supposed to be putting the finishing touches on a new system, named Basel III after the Swiss city where it was agreed in 2010, that subjects global banks to higher capital requirements, making them better able to absorb losses in future financial crises.

On this measure, a small club – including Deutsche, BNP Paribas, Citigroup and UBS – makes up the world’s strongest banks today, with a ratio of equity to risk-weighted assets of more than 10 per cent. They are well ahead of the target: regulators have demanded that the world’s biggest banks have 9.5 per cent ratios by 2019.

But this summer officials around the world have upped the ante again. Suspicious that banks are finding dubious ways to comply with Basel III, they are leaning more heavily on an older, less sophisticated measure of debt levels: the leverage ratio.

“What it does is it points out that when you compare apples with apples, the institutions on both sides of the Atlantic are highly leveraged institutions and I don’t think we do ourselves a favour by pretending they’re not,” says Tom Hoenig, an advocate of the leverage ratio from his perch as vice-chairman of the US Federal Deposit Insurance Corp, which supervises US banks and guarantees their deposits against default.

It differs from the main Basel III ratio, which allows banks to use models to decide whether a certain loan or security is risky and needs more equity to deal with a potential default – or safe like a US Treasury, which needs no equity at all.

Work by the Basel Committee on Banking Supervision, which gathers the major regulators from around the world, has shown a huge inconsistency in the ways these 'risk weights' are applied, with some banks using only one-eighth as much capital as their competitors for the same trading assets. Their findings have led some to conclude that either the models are not working or banks are cheating.

The banks have an incentive to get their ratio higher by massaging down their assets: though more equity capital makes a bank safer, it also makes for a lower return on equity. This is a benchmark that investors use to compare stocks and it is also used in the calculation of bankers’ bonuses.

The leverage ratio is supposed to make massaging impossible as it measures equity against total assets with no risk weights. It is a blunter, simpler backstop: a dollar is a dollar whether it is a risky loan or safe government bond. The disadvantage, say bank executives and some officials, is that, without risk weights, it can tempt banks to move to riskier loans that earn higher returns but are more likely to result in losses.

“Taking into account capital cost and returns the leverage ratio incentivises high-risk business,” Sabine Lautenschläger, deputy president of the Bundesbank, Germany’s central bank, says. “The leverage ratio doesn’t give you an idea of the risks in the bank. In Germany there are banks with high leverage but a large part of their business is financing the German government and German communities. You wouldn’t say these banks are high-risk.”

Despite some regulators’ reservations, the Basel committee has pressed ahead with a supplementary leverage ratio that should for the first time subject global banks to a standard set of simple rules.

In the past two months, the topic of leverage, once barely mentioned in conversations between banks, regulators and investors, has leapt to the top of the agenda for all three constituencies. And suddenly banks that have looked healthy because they have large amounts of assets that they manage to classify as risk-free, such as Deutsche and Morgan Stanley, have been found wanting.

Or they would be if they disclosed the same number. Because what regulators such as Hoenig see as the gold standard of capital has been tarnished by the same problems that have dogged comparisons of banks’ strength for decades: a lack of transparency, competing national rules, and arguments over whether banks might be complying by cutting off lending or finding room between the spirit and letter of the law.

Analysts in the US and Europe peppered the banks with questions about leverage after the most recent round of earnings reports. They were trying to work out whether the banks were well-positioned for the new targets or whether they were undercapitalised.

They did not receive uniformly transparent answers. Deutsche’s chief financial officer Stefan Krause, for example, would offer only a measure of leverage on a European standard that looks to be overtaken by the tougher global requirement. Even under its chosen measure, it was barely compliant. Harvey Schwartz, Goldman Sachs chief financial officer, shrugged off seven attempts to get to the bank’s leverage, saying only that it was “pretty comfortable”. Of the major banks, Citi made the best stab at answering the question, providing estimates for its leverage ratios on both US and international standards.

Why competing standards at all? Confusingly, for the supposedly simplest, bluntest metric, there are multiple ways of calculating leverage. Andrew Fei, associate at Davis Polk, the law firm, says: “The way I see it, there are at least six different leverage ratios in the US, EU, UK and Basel committee, depending on how one counts them.”

Although the goal is to measure equity against assets, different countries and banks have different preferences on what should be included in the calculation. The biggest difference has been the US allowing its banks to report a ‘net’ number for derivatives exposure, so that if it sold $10 million of insurance through credit derivatives from a company and took $1 million of cash collateral it would report a $9 million exposure. Under international rules it would have a $10 million exposure.

Ironing out the global discrepancies is hard, but changes the calculation on leverage quite dramatically. US banks, with the support of some officials, have long pointed out that their leverage ratios are better than those of the Europeans. Hoenig accused Deutsche of having “horrible” capital levels in an interview with Reuters.

Using the existing US accounting rules Deutsche’s assets shrink from $2.3 trillion to about $1.6 trillion, compared with about $2.4 trillion at JPMorgan. While Deutsche provides numbers under US rules, JPMorgan does not provide an international measure of its assets. Hoenig’s estimates, disputed by some bankers and officials, gives JPMorgan a $4 trillion balance sheet.

Deutsche also argues that it loses less money than US rivals. Krause’s presentation last month contained a slide that listed the loan loss ratios of unnamed banks on one side of a chart – whose weaker members happened to correlate closely with US banks such as JPMorgan and Bank of America – contrasted with Deutsche huddled in the safe corner with a couple of other European banks. JPMorgan and BofA declined to comment, though US executives argue that focusing on the riskiness of loans ignores the riskiness of trading assets that constitute a greater share of some European banks’ balance sheets.

But Deutsche and other European banks unused to having to comply with a leverage ratio are going to have to meet the new rules. This might make their US rivals happy were it not for the fact that US regulators, including the Federal Reserve, are proposing to go even further.

Shortly after the Basel committee announced its leverage ratio, with a 3 per cent minimum of equity to assets, US regulators announced a higher one with a 5 per cent minimum for bank holding companies and 6 per cent for subsidiaries.

Jamie Dimon, chief executive of JPMorgan, cried foul. “It doesn’t have to be exactly the same to have a competitive marketplace,” he said in July. “We always ran with higher capital and liquidity than most of our competitors. I just think if one is 3 per cent and one is 6 per cent, that [gap] becomes just too big and over time it can have huge competitive effects. This is clearly no longer harmonisation. We have one part of the world that’s talking about two times what another part of the world is talking about.”

At the moment, Dimon may be overstating his case because the Fed’s rule uses a more lenient calculation of assets; though higher, the US standard is not twice as high. But the Fed has said explicitly that it might adopt the new international standard and there is no reason to doubt it will.

Worryingly for the US banks, the Fed no longer seems too concerned with industry’s demands for a level playing field across the globe. Daniel Tarullo, the Fed governor in charge of regulation, says “these international standards are floors, not ceilings. National regulatory authorities should require higher capital levels – either across an industry or for specific institutions – where necessary to ensure financial stability.”

The Fed has moved a long way from 1992 when Alan Greenspan, then chairman, told Congress that the leverage ratio would be made redundant by risk-based capital standards: “I believe we will be able to fairly quickly dispense with it,” he said. In 2005 a different Fed governor said it “has got to disappear”.

But if risk-based capital has lost some popularity because of its ability to be “gamed” by banks, the leverage ratio is not completely immune from creative solutions.

While Barclays and Deutsche have raised equity, banks are also examining less transparent paths to meet new rules. Analysts at Goldman Sachs noted in research for clients that “banks have a lot of options to mitigate the impact” – including shifting assets between subsidiaries, shortening the duration of derivatives and reducing credit commitments.

Some of those steps would have the effect of reducing banks’ overall credit exposures but others would not. Deutsche is even looking to reduce its cash holdings – a bastion of liquidity that could be vital in a crisis – because such a reduction would cut the assets and raise the leverage ratio even if it did nothing to curb risk.

But whatever the regulators’ solution, investors will do their own sorting of the banks. If officials are rediscovering the joys of simplicity they are only following the market. Stock performance correlates much better with leverage than with risk-based regulatory ratios. That elite club of banks with a ratio of more than 10 per cent under Basel III are not all darlings of the market. Some trade at a discount to banks with lower headline capital levels such as Royal Bank of Canada and Wells Fargo, both of which happen to have better leverage ratios.

Banks that have stretched to meet new leverage requirements may have to keep doing so, says Philipp Hildebrand, who fought for tougher standards as head of the Swiss National Bank and is now vice-chairman at asset manager BlackRock.

“I still think it’s too low,” he says. “At the end of the road you have 3 per cent capital against total assets: that’s a tiny sliver of loss protection. If I had to guess I would say that we would end up in a world – whether by regulatory constraints or what the market demands – that would be closer to a 5-7 per cent leverage ratio.”

The micro battles over definitions are part of a broader war the banks are losing, he says. “I think people are beginning to recognise that the argument that strong capital levels undermine growth is factually and empirically and analytically wrong.”

Copyright the Financial Times 2013.