On Tuesday, I had the pleasure of testifying before the House Financial Services Committee on a wide range of bank regulatory topics, including the regulation of bank capital.  Much of the discussion focused on the use of a leverage ratio to measure a bank’s capital adequacy.  As I explained in my written testimony and opening statement, the leverage ratio is highly problematic.

First, as a general matter, leverage ratios are poor measures of a bank’s capital strength.  The supplementary leverage ratio measures the capital adequacy of a bank by dividing its capital by its total assets and off-balance sheet exposures.¹   Although sometimes viewed as an alternative to risk-based capital, the leverage ratio is, in fact, also a risk-based measure of capital - albeit a very inaccurate one.  It assesses the risk of holding every asset to be exactly the same – akin to setting the same speed limit for every road in the world, whether it's a highway or a school zone.  Although the risk-weights used in risk-based measures can sometimes be wrong about the risk of an asset, a leverage ratio is almost always wrong.  

This inaccuracy is especially pronounced for banks engaged in capital markets or custody activities, or those holding large amounts of liquidity – all involve large quantities of cash, Treasuries or other low-risk assets, which a leverage ratio penalizes harshly, requiring much more capital than economics and risk would otherwise suggest.  While leverage ratios can be useful as a simple backstop to other primary measures – namely, risk-based capital ratios and robust stress-testing – their one-size-fits-all view of risk is so inconsistent with the actual economics and risks of banking that, if it is set at a level that binds, a leverage ratio would inevitably frustrate and distort the allocation of credit to the economy.  

To put a finer point on just how pronounced an effect a binding supplementary leverage could have on lending and the real economy, it’s useful to consider some simple numbers.  For example, if the entire U.S. banking were to meet a 10% supplementary leverage ratio, the current capital of the U.S. banking system would support at least $4.8 trillion less in loans and other productive activities than it currently does today.²   The economic ramification of such an enormous reduction in lending capacity would be extraordinarily negative.  

The supplementary leverage ratio is a poor measure of capital, both in theory and in practice.  We would be much better served by limiting and discouraging its current use, rather than expanding and encouraging it.

¹A traditional leverage ratio only divides a bank’s capital by its total balance sheet assets; it does not take into account off-balance sheet exposures.  The supplementary leverage ratio, which was introduced in Basel III and currently applies only to larger U.S. banks (14, to be exact), takes into account both.

²Because that number may be surprisingly large to some, here’s the math:  Currently, the entire U.S. banking system holds $1.7 trillion in tier 1 capital, and $ 21.2 trillion in aggregate total assets and off-balance sheet exposures.  At a 10% supplementary leverage ratio, that $ 1.7 trillion in capital could support only $16.4 trillion in assets and off-balance sheet exposures - $4.8 trillion less than today.  This actually understates the likely impact – the vast majority of U.S. banks (i.e., all but 14) are not currently required to calculate or hold leverage capital against their off-balance sheet exposures.  If they did, the reduction in lending capacity would be even higher.

Disclaimer: The views expressed in this post are those of the author and do not necessarily reflect the position of The Clearing House or its membership.