Why the Leverage Ratio doesn’t reduce risk, it just moves it around (Premium Content)

The value of the Leverage Ratio has been proclaimed as a non-risk based measure that is supposed to capture all on and off-balance sheet liabilities of a bank. Together with risk-based measurements, the Leverage Ratio is supposed to ensure that bank risk does not get out of hand. Most regulators seem pretty happy with this idea. However, we are finding more and more evidence that the Leverage Ratio, as the recognized gating factor in Securities Finance Transactions and other kinds of trades, is really not good for banks, or the markets, at all.

The latest argument in favor of the Leverage Ratio comes from the European Central Bank in their annual Financial Stability Report. In “The impact of the Basel III leverage ratio on risk-taking and bank stability,” by Michael Grill, Jan Hannes Lang and Jonathan Smith, the authors argue that a the Leverage Ratio makes banks hold more capital than they would otherwise, resulting in less risky banks:

Theoretical considerations and empirical evidence for EU banks suggest that the introduction of [a Leverage Ratio – LR] requirement into the Basel III regulatory framework should lead to more stable banks. This special feature has shown that although there is indeed an increased incentive to take risk once banks become bound by the LR, this increase is more than outweighed by the synchronous increase in loss-absorbing capacity attributable to higher capital. The analysis therefore supports the introduction of an LR requirement alongside the risk-based capital framework. The analysis further suggests that the LR and the risk-based capital framework are mutually reinforcing as they each cover risks which the other is less able to capture; ensuring banks do not operate with excessive leverage and, at the same time, have sufficient incentives to keep risk-taking in check.

The Wall Street Journal read this as a Leverage Ratio of 4% to 5% should result in the most beneficial impact. Our read was that once the Leverage Ratio hits 5%, the probability of bank distress doesn’t go down very far thereafter.

While we agree that a lower Leverage Ratio makes banks more stable, it can also true that banks that do no business at all are really the most stable. Put another way, risk and credit intermediation are part of the business of a bank. You can’t have one without the other. Reducing the Leverage Ratio just means that banks can’t do their business. What happens then?

Bloomberg picked up that one opposing view of the value of the Leverage Ratio comes from Sweden’s Finansinspektionen. In a note from July 3, 2015, they pointed out that the Leverage Ratio increases market risk by dispersing risk-based activities outside of banks:

If non-risk-sensitive capital requirements – such as a leverage ratio requirement or standardised floor – are set at a level that makes them the binding capital restriction, Sweden may end up with a smaller, but riskier banking system. A larger proportion of credit supply is then likely to take place via the financial markets. This means more financing channels, which could contribute to greater efficiency. But it could also result in credit supply becoming less stable.

The Finansinspektionen is saying that less risk concentrations in banks mean more risk outside of banks where regulators have no control. This doesn’t have to be Shadow Banking – it can just be regular market volatility. Regulators can set many parameters but can’t control for everything.

We would take this a step further. More risk outside of banks mean that banks, while holding lots of capital, have a much greater likelihood of being negatively impacted by market events outside of their control. This, we argue, decreases the inherent value of the Leverage Ratio as a bank de-risking tool. The risk still exists. It might be internal to a bank with the bank acting as credit intermediary, or external with the bank negatively impacted while the market swings around and the valuation of its HQLA goes up and down. The Leverage Ratio doesn’t hide the risk, it just moves it around.

The Leverage Ratio is a dicey proposition. It is not the fail-safe mechanism that the ECB and other regulators claim. Rather, it creates its own set of benefits and genuine risks in the marketplace. Derisking a bank protects from one set of complications but not others. Regulators must recognize the distinction and ensure that risk isn’t just shuffled around, but that risk is managed in the right places across the financial system. Otherwise all these new ratios are really just for naught.

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