Prophets

Treasury's Bank Plan Tightens Regulations by Loosening Them

All banks are overlevered in a crisis, and it does no good for regulators to cite them for it.

Treasury Secretary Steven Mnuchin has a plan for banks.

Photographer: Andrew Harrer/Bloomberg

The initial reaction to the U.S. Treasury Department’s report on scaling back financial regulation focused on the high-level assertions that excessive and badly designed rules were hurting the economy. The report is part of a long-running debate and is not likely to change many minds. Buried among its 149 pages, however, are specific details that are likely to influence the course of financial regulation. One of the more interesting points concerns the enhanced Supplementary Leverage Ratio, or eSLR. It illustrates how the report manages to tighten regulation by loosening it.

There are two approaches to limiting leverage. The older one uses standard accounting, but there are three problems: No adjustment is made for differences in volatility among assets, offsetting exposures that reduce risk increase leverage, and off-balance-sheet exposures are ignored. The result is accounting-based limits that encourage banks to hold the riskiest, highest-return assets, to hedge nothing, and to push exposures off the balance sheet.

Beginning in the mid-1980s, risk-adjusted measures that took account of volatilities, correlations and off-balance-sheet exposures become popular. The trouble is it takes complicated models to estimate the adjustments. Moreover, they can only tell you about the leverage if the bank’s models are correct. Regulators also have to think about risk if the bank’s models are wrong or gamed.

In the wake of the 2008 financial crisis regulators adopted both: a risk-adjusted rule plus the eSLR. Universal banks find the risk-adjusted requirement binding, while custody and dealer banks that hold low-risk assets bump up against eSLR first.

The Treasury report recommends three changes. The first is that certain low-risk assets be excluded from total assets. If this change is not made, banks might have to refuse deposits in a financial panic. Even if the funds are immediately deposited with the Federal Reserve they increase leverage, which forces either asset sales or equity raises in bad markets for both.

The second recommendation is to exclude initial margin requirements held by the bank for centrally cleared derivatives. Without this change, banks are penalized for requiring customers to post margin, even though holding margin makes banks safer. The third recommendation is more circumspect, in that it is “to consider addressing the calibration” of the leverage ratio for construction loans and loans to small and mid-sized businesses. The reason for the obscure language is that there is no financial rationale for this change, it’s a purely political decision to encourage a kind of leverage everyone likes: loans that create jobs in every congressional district in the country.

While there are good arguments for two of the recommendations, it is a bad idea to legislate them in specific form as opposed to general principles. The point of an accounting-based leverage rule, rather than a risk-based capital rule, is that leverage presents risks beyond a drop in the market value of assets. That’s why it treats all assets the same, regardless of volatilities and correlations.

All banks are overlevered in a crisis, and it does no good for regulators to cite them for it. You maintain prudent leverage ratios in good times so the ratios do not become infinite (that is, so your equity does not shrink to zero) in bad times. When bad times come, you ignore the leverage ratio and just try to survive.

By excluding central bank deposits and U.S. Treasuries from the leverage ratio, regulators are telling banks, “When the crisis hits and you cannot maintain your leverage ratio, put your assets in the central bank or in Treasuries, and we’ll both pretend that your leverage is fine.” The government is now specifying what banks do in crisis.

Excluding collateral in a leverage calculation has some points in its favor. However, excluding only initial margin for centrally cleared derivatives and not any other sort of collateral has no obvious justification, other than that regulators like central clearing of derivatives. The rule that collateral for favored purposes gets favored treatment increases regulatory power. The third recommendation, the stealth one, is even more obviously special treatment for favored banking activities.

The Treasury’s recommendations for eSLR are sensible policy but not deregulation. Passing overly strict regulation and then carving out exceptions for favored groups is more intrusive than strict regulations alone. Deregulation reduces the number of rules and pages, levels the playing field and reduces regulator discretion. The Treasury report recommends loosening rules to increase regulation.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

    To contact the author of this story:
    Aaron Brown at aaron.brown@aqr.com

    To contact the editor responsible for this story:
    Robert Burgess at bburgess@bloomberg.net

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