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The leverage ratio – silver bullet or snake oil?


Recent discourse on bank regulation has fingered the leverage ratio as a universal remedy for the drawbacks in risk-weighting models, the gaming potential and other imperfections in the latest Basel capital adequacy framework. Its advocates endow it with almost magical attributes, but its critics regard it as an over-hyped and primitive tool. Who is right?


What is the leverage ratio?


The leverage ratio is a simple, ancient measure of capital adequacy: capital divided by total assets, expressed as a percentage. (Or you can express it the other way round as a multiple – a leverage ratio of three per cent corresponds to a multiple of about 33 times.) ‘Leverage’ itself is a US term – the British equivalent is ‘gearing’, describing the enhancement of return a business owner expects by using not only his own capital, but also borrowed money, to finance the business. Since banking involves mobilising deposits and using them to provide loans, intrinsic leverage is bound to be high. The question is: how high is enough? And how would this measure affect BSA members?


The BSA’s view


The BSA recognises that model defects, gaming and other shortcomings may cause problems in other parts of the financial forest. So we support a moderate leverage constraint as a back stop, but not as the primary driver of capital adequacy. The difficulty arises if a high single leverage limit is applied to very diverse business models, especially those specialising in low risk asset classes, such as residential mortgages. (All building societies must concentrate on mortgage lending – by law, at least 75 per cent of their loan book must be fully secured residential mortgages – and this law reduces risk by making societies stick to a low risk asset class with which they are very experienced.)


The impact of leverage limits on building societies


The BSA has done some initial estimates of the impact of leverage limits on UK building societies based on actual figures for end-2012. To move from a three per cent to a four per cent limit, without raising new capital, building societies collectively would have to shrink their mortgage books by a quarter, by over £55 billion. An alternative way to look at the impact of moving from a three per cent to a four per cent limit is that the extra capital needed to maintain the current balance sheet amounts to approximately seven years’ retained profit at current levels.


Our concerns over a high single leverage limit extend beyond these aggregate impacts. Operating as the effective capital constraint, it creates immediate incentives for firms to move towards higher risk assets. The single limit punishes the prudent bank that holds high levels of high quality (but low return) liquid assets such as sovereign debt or central bank reserves, and the prudent building society that concentrates on safe, low-risk but low-return mortgage lending.


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It rewards the imprudent firm that runs its liquidity down to the bare minimum, holds riskier liquid assets and focuses its mortgage lending on higher risk areas – very high, perhaps > 100 per cent loan to value; marginal or stretched borrowers; and commercial real estate.


“To move from a three per cent to a four per cent limit, without raising new capital, building societies collectively would have to shrink their mortgage books by a quarter, by over £55 billion.”


Even where this limit does not drive firms away from originating low-risk mortgages, it strongly discourages holding them on balance sheet. BSA members have traditionally operated a prudent ‘originate to hold’ model, but a high simple leverage ratio limit subverts this approach, by pushing firms to hold the higher risk/higher return lending and to securitise the low risk lending. As a result their retained portfolios will be substantially riskier than the overall profile of loan origination. The BSA does not see how this can be sensible or desirable.


Is there a better way?


The BSA thinks so – and our views are in fact fully in line with the latest European legislative text. Thanks in particular to members of the European Parliament, this gives a strong steer towards leverage ratio limits differentiated by business model. MEPs put forward a three-tier approach (low-risk business models to have a limit of 1.5 per cent; average-risk three per cent; high-risk five per cent) which we think would make a good starting point. We look forward to working with the various European authorities to refine this into a sensible back-stop as originally intended.


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