Basel Committee Misses the Point in Redefining Leverage Ratios

The Basel Committee’s recent decision to change the definition of the leverage ratio is bad news for two reasons.

There’s the obvious: A smaller denominator means less capital. The leverage ratio requirement says, in principle, that banks must have capital equal to at least X% of their total unweighted assets, where “assets” is supposed to include anything they hold that could fall in value. Take some bank that has some amount Y of traditional assets and other things that could fall in value, like derivatives positions. Then it has to have capital equal to X * Y / 100. If we take the exact same bank but decide to call Y some smaller number, say Z, then it can get bay with less capital. Less capital = more risk.

Then there’s the slightly less obvious. The whole point of the leverage ratio is to safeguard against the ability of banks to game capital requirements based on risk-weighted assets. Under Basel I and II, banks had to hold capital equal to some percentage of their assets, but those assets were weighted according to their perceived (or politically defined) risk. Most notoriously, all sovereign bonds had a risk weighting of zero, no matter what country issued them, so if all you held was Greek bonds, you didn’t need to have any capital. The leverage ratio is supposed to provide a backstop so that no matter how clever the bankers and their lawyers are, the bank still has to hold some capital.

For this reason, the definition of assets for leverage ratio purposes should really include everything you can possibly think of: non-netted derivatives, implicit guarantees to off-balance-sheet entities, everything. Then we can argue about what the percentage should be. But it makes no sense to have a leverage ratio definition that doesn’t include everything, because then banks will be able to game it. At the end of the day, we’ll just have two different risk-weighting mechanisms, each of which is fodder for clever lawyers and accountants.

The only partial hope is that the United States will hold the line with a strict definition of the leverage ratio and a higher percentage than that in Basel. This is the one thing that Tim Geithner promised when he was fighting every other serious attempt to solve the TBTF problem: higher, stricter capital requirements. Of course, now that the banks have had their way in Basel, they will use that as an argument for weakening U.S. capital regulations. It’s unlikely the Obama administration will try very hard to hold the line, given its record and the people who hold the economic policy positions these days. That more or less leaves Janet Yellen, who doesn’t have much of a record—good or bad—when it comes to standing up to big banks.

This piece is cross-posted from The Baseline Scenario with permission.