Bank executives like to say that their most important job is managing risk. This does not mean they’re good at it. Banks the world over have often failed to monitor hazards properly, blowing up spectacularly every few decades. Regulations drafted in the wake of the global financial crisis were supposed to curb dangerous behavior. Yet the complex new rules repeat a mistake that led to the banks’ troubles in the first place: They assume bank executives and regulators can figure out what is risky.
Now a handful of regulators on both sides of the Atlantic are pushing for a less complicated approach. They argue that the only way to make sure financial institutions don’t fail when their bets go bad is by relying on dead-obvious restrictions on leverage. For every dollar of capital a bank has, it can lend a fixed amount, say $10, regardless of how risky or non-risky it claims that loan to be. That way the bank can take any risk it wants as long as there’s enough shareholder equity to cover the potential losses—so taxpayers aren’t stuck with the tab if it collapses.
Andrew Haldane, executive director of financial stability at the Bank of England, and Thomas Hoenig, a board member of the U.S. Federal Deposit Insurance Corp., are the leading voices in this back-to-basics movement. “There’s scope for significant simplification of the rules,” says Haldane. “An advantage of the leverage ratio is that it doesn’t pick certain assets as winners and others as losers.”
Banks in some 100 countries are bound by the Basel Accords, a set of regulatory standards named after the Swiss city where officials gather to forge those rules. Under Basel, the minimum capital requirement is determined by looking at a bank’s risk profile, which institutions calculate using their own complex formulas. The third installment of the Basel framework, which countries will start phasing in next year, ratchets up the minimum ratio to 8 percent; it does not question whether banks do a decent job of estimating the risk of their own loan portfolios. “The whole Basel approach has failed miserably because it allows the banks to focus on gaming the system,” says Anat Admati, a finance professor at Stanford University. “The simpler you make the capital rule, the harder it becomes to game it. That’s why simple leverage can work better.”
In a paper presented at a gathering of central bankers in August, Haldane showed that the simple leverage ratio would have been a better predictor of failures in the last crisis. He also noted that the models banks use to measure risk involve millions of variables and assumptions, rendering them impossible to monitor for accuracy by regulators. Using its secret in-house formulas, Deutsche Bank (DB) calculates its risk to be 20 percent of assets. JPMorgan Chase (JPM) says about half its balance sheet is risky.
The latest Basel rules do introduce the simple leverage concept for the first time, though as a secondary requirement to the minimum capital ratio. Haldane has said the Basel target of 3 percent of assets is lower than he would like, though he has shied away from offering his own number. Hoenig has proposed 10 percent. Sheila Bair, former chairman of the FDIC, favors 8 percent. Senator Sherrod Brown (D-Ohio) has introduced legislation that would set a 10 percent leverage limit.
If U.S. regulators adopted Hoenig’s proposal as part of their implementation of Basel III, the four largest U.S. banks would have to increase their capital by $300 billion, according to Bloomberg Businessweek calculations. That would mean selling new shares or holding on to profits. Bank of America (BAC) would have to suspend its dividend for 12 years.
Banks have resisted calls for higher capital requirements, saying they would end up curtailing economic growth. Because there isn’t enough investor demand for bank shares, financial firms would have to reduce assets to comply with a higher ratio, bank executives say. That means less lending for companies and consumers. The Institute of International Finance, a lobbying group, estimated in 2010 that new financial regulations would shave 3 percent from global economic output. The International Monetary Fund recently published a study refuting such claims.
Unlike Hoenig, Haldane doesn’t advocate ditching Basel altogether. Bringing simple leverage to the forefront and pushing risk-based calculations to the background would make Basel much more powerful, Haldane argues. Bair agrees, especially if banks aren’t allowed to rely on their own risk models but are given standard risk scores for different asset categories. “Simpler and standard across-the-board risk weighting can help the leverage ratio in restraining banks,” she says.
Yet even standardized measures can fail to spot risk in advance. Before the subprime crisis, mortgage lending was assigned a very low risk factor, while the sovereign bonds of most developed nations were seen as risk-free. If there’s one lesson the world should have learned about banking risk by now, it’s that it’s unpredictable.