Britain | The leverage ratio

Never lever land

The Bank of England announces plans to make banks safer

IN 2008 Royal Bank of Scotland (RBS) was bailed out with £45.5 billion ($79 billion) of taxpayer funds, or £741 for every British citizen. The bank’s capital base had been insufficient to absorb heavy losses, in part because of regulatory lenience. When loans and investments began to turn sour, a costly rescue became necessary.

On October 31st the Financial Policy Committee (FPC) of the Bank of England made a long-awaited announcement on the leverage ratio, one of several new measures intended to guard against a repeat of the RBS episode. A bank’s leverage ratio gives the proportion of its assets funded by equity capital (which absorbs losses) rather than debt or deposits (which do not). Crucially, it is a measure of the losses a bank can sustain before its shareholders are wiped out, causing it either to fail or to rely on hybrid instruments—mixtures of debt and equity—which are unproven.

The FPC wants a minimum ratio for most banks of 3%, with extra buffers for the biggest banks, to guard against the economic cycle. These could bring the total required closer to 5%. The prescription was more lenient than expected, and banks are unlikely to struggle to comply. Citigroup, an American bank, estimates that only Barclays faces a capital shortfall—of just 0.2%—due to the measure.

Banks borrow more than other companies: the average leverage ratio of non-financial FTSE 100 firms is 37%. There are many reasons for the disparity. One is particularly pernicious: big banks can expect to be bailed out if they fail, so their debt is cheaper. This implicit subsidy is in the sights of regulators like the FPC. As capital requirements increase, the probability of failure falls, and with it the subsidy.

A leverage ratio of only 3-5% will not do the job on its own; the biggest losses during the crisis exceeded 6%. Rather, the FPC sees it as complementary to risk-weighted measures, which ensure banks holding risky assets (such as derivatives) are better capitalised than their more cautious peers. But risk-weights are partly determined by banks’ own models and judging risk is difficult. In the run-up to the financial crisis, mortgage-backed securities and Greek government bonds were thought safe.

Some banks claim the leverage ratio inhibits lending. Equity is more costly for them than debt, and those costs might be passed on to borrowers. But the differential mainly reflects the too-big-to-fail subsidy and tax advantages of debt, both of which are costs borne by the taxpayer. The case for this indirect subsidy for lending has not been made explicit.

Nonetheless, this claim might explain politicians’ aversion to tough capital requirements. In 2012 George Osborne, the chancellor of the exchequer, rejected a proposal from the government-appointed Independent Commission on Banking (ICB) for a 4% leverage ratio for the biggest banks, having previously warned against promoting the “stability of the graveyard”. In 2013 Vince Cable, the business secretary, inveighed against the Bank of England’s “capital Taliban”.

Despite those interventions, big banks will now face requirements similar to the ICB proposals, once the buffers are included. The ICB wanted to be tougher still, but said a higher ratio could only be implemented internationally (lest banks relocate to more lenient countries). The Basel III committee, an international regulatory body, is examining a leverage ratio, but of only 3%.

Bank shares rose strongly on the FPC’s announcement as analysts rejoiced. But tougher rules may yet emerge. The Basel III leverage ratio could be higher when it is finalised in 2017. And next week, proposals on another international measure—“total loss-absorbing capacity”—will be announced at the G20 summit. That should do more to protect the taxpayer.

This article appeared in the Britain section of the print edition under the headline "Never lever land"

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