In the news: The leverage ratio

Paul Tucker (Photo credit: CBI)

This week, Paul Tucker, the outgoing deputy governor of the Bank of England, called for a 3% leverage ratio to be immediately applied to all UK banks – well ahead of the international deadline of January 1, 2018. While it is unlikely that the government will leap to do his bidding, he is one of many calling for similar (and probably higher) ratios to be applied to banks.

At its heart, the leverage ratio is a very simple concept, measuring the ratio of a bank’s borrowing to the stuff it actually owns. Defining the two elements becomes problematic very, very quickly, however, so we’ll stick to a simple definition.

On the numerator, we have equity. This is made up of elements such as retained earnings, shares, and reserves - solid stuff that a bank can use to pay its debts when the bailiffs come knocking.

On the denominator, we have debt. This is all the money the bank owes to someone else, ranging from money borrowed short-term on the overnight market to bonds issued with a maturity of many years. In the run up to the global financial crisis, banks’ reliance on debt, particularly the short-term, overnight kind, was a major reason behind the collapse.

This leaves us with:

With this in mind, Tucker has called for a 3% ratio, at least in the short term, which happens to be the same number set by the Basel III framework. Basel III is an attempt to get regulators to apply common minimum standards of regulation to banks worldwide, and includes minimum capital requirements, a leverage ratio, and a couple of liquidity provisions. The Basel III definition of the leverage ratio is a bit narrower than mine, but it runs to 22 pages so we’ll stick to the simple version for now.

A 3% leverage ratio means that, on the above definition, equity must be at least 3% of total debt, such that a bank may borrow 33 (thirty-three!) times as much as it holds in equity. If this sounds like a lot, you would be right. Commentators such as Mervyn King and John Vickers agree, and have advocated leverage ratios as high as 10%, which would still allow banks to borrow ten times their equity.

There are problems with the leverage ratio, however. Most notably, it is a clumsy tool, which does not differentiate between hyper-risky derivative products that the banks themselves don’t fully understand and safe(r) products such as government debt.

The leverage ratio is designed as a catch-all ‘backstop’ to complement other elements of Basel III, such as the capital requirements, which apply complicated risk-weights in order to better capture the riskiness of banks, but which allow banks to do the sums themselves using such impenetrably complex models that the regulators are never quite sure what is going on inside. The leverage ratio is just one tool in a sizeable toolkit.