Departing Fed Governor Tarullo says a 10% Leverage Ratio would incentivize banks to change the composition of their balance sheets dramatically

Departing Thoughts

Governor Daniel K. Tarullo

At The Woodrow Wilson School, Princeton University, Princeton, New Jersey

There has been much discussion of late of the leverage ratio requirement, from multiple perspectives. There are proposals to make a higher leverage ratio requirement either mandatory or optional for banks, which would then be relieved of risk-weighted capital requirements and many other prudential regulations. There are also those who have questioned the relative cost-benefit tradeoff of the “enhanced supplementary leverage ratio,” the 2 percent surcharge applicable to all eight U.S. G-SIBs.

Increasing the current 4 percent or 5 percent leverage ratio requirement to, say, 10 percent would certainly yield a very well-capitalized set of banks based on the current balance sheets of large banks. But one needs to look at the dynamic effects of such a requirement. Since a higher leverage ratio would also make banks less profitable, and with the constraints of risk-based capital and liquidity requirements lifted, they would be strongly incentivized to change the composition of their balance sheets dramatically, shedding safer and more liquid assets like Treasuries in exchange for riskier but higher-yielding assets. After all, with a leverage ratio as the only significant constraint, the regulatory cost of holding a short-term Treasury bill is identical to that of a junk bond. It is this very limitation of a leverage ratio that led to the creation of a complementary risk-based capital requirement in the 1980s. To truly assure the safety and soundness of the financial system, a leverage ratio serving as the sole or dominant form of prudential regulation would probably have to be set considerably higher, at a level where the impact on financial intermediation could be quite substantial.

The full speech is available at https://www.federalreserve.gov/newsevents/speech/tarullo20170404a.htm

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