Sense and
sensitivity
The leverage ratio: risk-neutral, yet risky
One of the most important lessons from the
financial crisis is that measuring, managing
and monitoring risks in the financial system are
critical to future safety, writes Kevin Nixon
LEVERAGE RATIOS
A leverage ratio does not, and in fact
cannot by definition, take into account
the riskiness of the asset base
Photography: Shutterstock
I
t was clear from the financial crisis that both the
quality and quantity of bank capital needed to
improve, and Basel 3 has already moved the
industry in that direction.
Essentially, the bank capital regulatory framework
needs to be risk-sensitive to ensure that resilience is
appropriately calibrated and also that riskiness of
activities can be measured and monitored across
institutions and the broader financial system.
However, rather than focus on what qualifies as bank
capital, or how much a bank should have on its balance
sheet, we need to look at on what base it is measured.
If the leverage ratio were to be the primary form of
capital regulation, it would create a system that
incentivises the accumulation of riskier assets without
requiring more capital against those risky
undertakings. Further, if it becomes the primary, and
therefore “headline” number for bank capital, then
comparing two banks becomes meaningless. Two
banks with identical leverage ratios could have
completely different risk profiles, yet this would not
be evident to either investors or supervisors on the
basis of the leverage ratio alone.
Leverage ratio – risk insensitive
A leverage ratio does not, in fact cannot by definition,
take into account the riskiness of the asset base.
Therefore a bank must reflect the same amount of
capital against a one-week US Treasury bill as it does
for a ten-year loan to a politically unstable, fiscally
challenged, emerging market country or a loan to a
business with a bad credit history. This would seem
highly inappropriate. Further, since return is correlated
to risk, such a framework creates an incentive to invest
in riskier assets seeking a higher return on equity,
without a consequent increase in capital.
Of course banks should assess capital on an
economic basis against the risk of their activities.
However, there is no question that for regulatory
policy to create the right incentives, a strong link
There has been significant debate regarding whether a
non-risk-based leverage ratio should become the
primary, or for some proponents the sole, form of
bank capital regulation. Basel 3 introduces a global
leverage ratio as a backstop to the existing riskweighted asset framework, so the existence of a
leverage ratio, once finalised, will form an important
element of that framework.
The debate then is not whether there should be a
leverage ratio, but rather whether it should become
the binding determinant of bank capital. These
arguments are inextricably linked to an assessment
and consideration of the current risk-weighted
framework and whether it is meeting its objectives.
Risk insensitivity and incentive
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27
LEVERAGE RATIOS
between internal risk practices and regulatory capital
should be maintained.
The more binding the leverage ratio is, the more
internal measures – and risk management in general
– will lose their grip. For example, despite a strong
risk culture in any given firm, it will make it more
challenging for the risk function to communicate to
the business function the need to mitigate risk in
cases where this will not lead to a reduction in
regulatory capital.
Comparability
Two banks reporting identical leverage ratios, even
operating in the same markets, give investors,
analysts and supervisors no indication of their
relative capitalisation given their risk profiles. One
bank could be providing home loans to highly-rated
borrowers with low loan-to-valuation ratios, while
another could be
lending in the
subprime sector with
high loan-tovaluation ratios.
Both banks could
have the same size
balance sheet and
hence under the
leverage ratio would report the same levels of capital.
If this were the primary or sole measure of bank
solvency then there is no indication of the relative
riskiness of the operations.
In order to assess such riskiness a robust riskweighted measure is required, but more importantly,
to ensure that higher capital is allocated for relatively
riskier operations and to give comfort to observers,
investors and supervisors that financial stability
drivers are being measured and managed, a riskweighted calculation should be both the binding and
the headline constraint.
...a risk-weighted calculation
should be both the binding and
the headline constraint
Basel – designed for better risk
measurement and management
1988
The year the Basel Accord (Basel 1)
was published
The Basel framework was established 25 years ago to
develop a standard global risk-based approach to
regulatory capital, in order to address, among other
things, the two issues above. Starting with a
standardised framework (Basel 1) where risk weights
were set by asset type and counterparty risk, the
framework evolved to one that allowed regulatoryapproved and validated internal models (Basel 2),
relying upon actual loss experience data, to more
accurately reflect riskiness of activities.
Under the Basel 2 framework the
standardised approach could be
seen as a catch-all backstop.
That is, absent a more
empirical approach this is the capital a bank is required
to have on its balance sheet. However, should a bank
implement a more rigorous analytical model based on
actual loss experience then the capital allocated against
its activities can more accurately reflect the riskiness of
such activities. In appropriate cases, the capital
requirement might therefore be lower than under the
standardised metric. In other words the regulatory
framework provided an incentive for banks to
understand better and to model default rates, rather
than rely on a somewhat arbitrary global number.
Two key metrics in the framework are the
Probability of Default (PD) and the Loss Given
Default (LGD); that is the probability that a
counterpart defaults on its obligations, and, if that
default does occur, what loss can reasonably be
expected to occur. The framework therefore creates a
further incentive to invest in better lending standards
and risk management. If banks can improve their
lending standards such that they can demonstrably
lower the PD then they will require lower capital. If
they can improve their risk mitigation or recovery
procedures and defaulted asset management then
they can likewise lower the LGD and as such lower
their capital requirement.
Risk-weighting under fire
In recent years, despite the great advances made in a
risk-based approach to bank regulatory capital, the
current Basel framework has come under criticism.
Again, the discussion here is not about the quality or
quantity of capital, but on what basis capital
requirements are determined. The criticisms can be
categorised as follows:
Transparency
The use of internal models necessarily entails the use
of proprietary data and a great deal of specific analysis
of portfolios, better reflecting the true complexity of a
bank’s exposures, but has led to concerns over lack of
transparency. Further, the use of internal models has
seen a great deal of commentary regarding banks
“using black boxes”, “gaming the system” or
“determining their own capital levels”.
Some of these criticisms are just ill-informed. No
bank is allowed to “determine its own capital level”:
internal models are constrained by well-developed
regulatory requirements and methodological literature.
Further, bank internal models are only implemented
after a thorough supervisory approval process, and
their continued use predicated on regular supervisory
assessment and validation. None of the official analyses
of variations of bank capital conducted by the Basel
Committee and the European Banking Authority has
found any significant “gaming” of the system.
However, there are a number of legitimate
transparency issues to be addressed.
The Financial Stability Board had the
transparency issue in mind when establishing the
Enhanced Disclosure Task Force, which made 32
recommendations to improve the quality of risk
disclosures. Initiatives such as this will
continue to develop, and are the best
means by which to improve
transparency and remove
some of the misunderstandings. Banks are working
toward greater clarity and consistency of disclosures
on this basis.
Complexity
The risks on a bank’s balance sheet, even a simple
bank, are complex, stochastic, non-linear and
interrelated and the mathematics, while well
understood by academics and practitioners, is
nonetheless complex to most.
Simplicity therefore should be sought where
possible, but it should not sacrifice the necessary
mathematics and data analysis, as this ensures the
risk-sensitivity remains appropriately calibrated.
“Simplicity” that merely masks underlying complexity
will create distortions that will become dangerously
complicated over time.
Comparability
Under the Basel framework two banks of equal
nominal balance sheet size may have very different
capital requirements. This is a design of the system.
The two banks may have a very different asset mix,
and may have very different risk management
techniques. Further national discretion under the
Basel framework (for example, allowing for higher
degrees of conservatism) can be a significant barrier to
comparability. Based on a recent Basel Committee
further investigation. Coupled with this analysis, the
Basel Committee has also published a discussion paper
titled The regulatory framework: balancing risk
sensitivity, simplicity and comparability, which is open
for comment until October 11.
Leverage ratio – a viable alternative
or a dangerous approach?
The Base
l Commit
tee
on Bankin
g Supervis
ion
defines th
e leverage
ratio as t
he
"Capital M
easure
(the num
erator) div
ided
by the Ex
posure
Measure
(the
denominat
or)"
There are a number of proponents who, emphasising
these criticisms of the current Basel framework, call
for the replacement of the risk-weighted framework
with a leverage ratio. If that were to take place then
superficial transparency of the application of the
standard would be improved, but the application
would not be all that simple as there is a high
degree of complexity in bringing off-balance
sheet items into the ratio, and finally
transparency and comparability of risk would be
lost to both banks and their supervisors.
As noted above, Basel 3 contains a leverage
ratio as a backstop. As a backstop it provides an
additional metric for supervisors, and provides a floor
to the risk-weighting process. The current Basel 3
leverage ratio is intended to be, and should remain,
calibrated to achieve that outcome. However, if the
leverage ratio is moved higher relative to the riskweighted requirement it is likely to become the
binding constraint, and the risk-weighted capital
calculation becomes the backstop. The US
supplementary leverage ratio proposal (6%
for banks and 5% for bank holding
companies) certainly raises this concern.
Is it a problem if the leverage ratio becomes
the primary or sole form of bank capital
regulation?
The short answer is yes.
Leverage on a balance sheet increases risk,
but not all risks are equal. The riskiness due to leverage
is directly related to the riskiness of the asset. Not all
assets are as risky as each other, but the leverage ratio
treats them as such. The correlation of potential loss to
available loss absorbency is lost. Further, it does not
provide a metric for assessing risk in the system, nor
comparing the riskiness of business models.
If there are areas for improvement, or deficiencies,
in the Basel framework they are being addressed as
they are identified by the Basel Committee, but it is
imperative for the stability of the financial system
that an appropriately high level of risk-sensitivity is
maintained. A significant amount of work has been
undertaken by supervisors (and industry) over the
last 25 years of developing a risk-based system, and it
is important to stay the course to ensure risksensitivity remains the primary driver of bank capital
regulation.
As noted in the introduction, one of the most
important lessons from the financial crisis is that risks
in the financial system must be measured, managed
and monitored. A leverage ratio as the primary or sole
means of bank regulation fails
on all three counts. In fact,
for all the reasons noted above
Kevin Nixon is managing director of
it can be counterproductive to
regulatory affairs at the Institute of
International Finance and is based
the safety, soundness and
in Washington DC
resilience of the system.
Photography: Shutterstock
Leverage on a balance sheet
increases risk, but not all risks
are equal
review, the combination of objective differences and
regulatory choices explains most of the divergences
observed in banks’ risk-weighted assets (RWA).
However, concerns have been raised that even after
accounting for these differences, there are divergences
that can only be explained by differing internal
modelling approaches.
Transparency on risks and jurisdictional supervisory
discretion can be helpful in this regard. There is a
range of proposals currently under discussion for
diminishing divergences arising from different
modelling approaches, ranging from common data
sets to more standardised definitions, to parameter
constraints, to benchmarking that are actively being
discussed. This body of work is extensive and
developing, and the work of the Basel Committee in
particular in this regard is noted below.
These concerns should be addressed and can be
addressed to preserve an appropriately calibrated risksensitive framework. The Basel Committee has
already undertaken comparability analyses of both
the trading book and banking book, both in terms of
RWA to nominal assets and across a standard
hypothetical portfolio.
While the results are preliminary, and a great deal of
further detailed work needs to be done, they show that
a degree of divergence exists, much of which can be
explained, but that a portion would appear worthy of
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