Shortcomings of the Leverage Ratio

Shortcomings of the Leverage Ratio

This week The Clearing House published a new research note — Shortcomings of Leverage Ratio Requirements.

Bank capital requirements come in two basic types:  Risk-based capital requirements that require banks to hold more capital for riskier assets and less capital for low risk assets.  And leverage ratio requirements that require banks to hold the same amount of capital for any type of asset, regardless of its risk.

The note explains that leverage ratio requirements have a number of shortcomings because they require banks to hold the same amount of capital against riskless assets as risky assets.  For example, the leverage ratio requirement requires U.S. banks to hold $53 billion in capital against deposits at the Federal Reserve Banks, which are riskless, capital that could be deployed instead toward productive lending to businesses or households.

The research note demonstrates:

• For large U.S. banks, the leverage ratio requirement is now so high relative to risk-based capital requirements that it frequently acts as a potentially binding constraint, shaping business decisions, rather than solely as a backstop.

• A higher, or more constraining, leverage ratio requirement induces banks to take on more risk.

• The leverage ratio is a poor measure of bank risk.  Approximately one-third of the banks that failed during the 2008 financial crisis had leverage ratios above 10 percent just prior to the crisis.  That is, 125 banks had leverage ratios above 10 percent but nevertheless failed.

• The supplementary leverage ratio is having a significant influence on bank behavior and financial markets by forcing banks to pass costs to customers for engaging in relatively low risk capital market activities.

The note concludes by suggesting that regulators recalibrate the enhanced supplementary leverage ratio (eSLR) to have it once again serve as a backstop measure. Such a recalibration would appear to have significant benefits and minimal costs and could be easily accomplished, because the eSLR is set by the U.S. bank regulators, not by law, and is not part of an international agreement.