On Sunday, the Governors and Heads of Supervision (GHOS) will meet in Basel and, if it can, hammer out a compromise on the global leverage standard. U.S. banks – as well as several of their regulators – are increasingly optimistic that the rule will be significantly revised from the contentious proposal. If it is, count on widespread conclusions that regulators have again kow-towed to big-bank muscle tactics. Is the industry ready to explain why the revised approach makes more sense than the proposed one – which I think it will? If not – and the record book here is not encouraging – then this win will come at high cost.
I am a new-found and still-doubting convert to leverage capital. For years, I argued that risk-based capital makes the most sense because assigning capital without regard to risk is akin to dressing without regard to height or weight. A garment appropriate for a 5’ 7” 250-pounder is ludicrous on a svelte, tall model and, so too is a high capital requirement meant for leveraged corporate loans to high-risk companies irrelevant to, say, a sovereign obligation or low-risk, collateralized loans. Indeed, crude capital ratios are worse than simply irrelevant – they create perverse incentives to hold low-risk assets, add unnecessary cost to liquidity-risk management, and distort fixed-income markets in favor of “shadow” firms happily subject either to sensible capital rules or none at all.
But, as I have come to agree, banks and their regulators can have more fun than is good for them determining risk-weighted assets (RWAs). The Basel Committee’s recent analyses of RWA practices around the globe prove the wide disparities in weightings for like-kind assets among banks and across the globe. And, again as we learned the hard way, high-quality assets aren’t always what they seem when put under stress or when held in trading books subject to fire sales that can sometimes mount to systemic firestorms. The best way to deal with this is to fix RWAs, a step Basel has so far been unable to take. So, leverage does make sense, as long as it’s taken in small doses carefully calibrated to make the crude constraint a back-up – not binding – one. So, what does Basel plan? First, it says it wants its leverage rule to be a backstop, setting the ratio at 3% of on- and off-balance sheet assets to create a floor below RWAs. However, what’s an “asset?” There’s where the controversy really kicks in. International accounting standards measure assets on a largely gross basis, while GAAP in the U.S. is nuanced to count a lot of hedging. The U.S. approach thus determines net assets, reflecting the expectation that a firm is exposed only to its bottom-line risk since it’s gone to all the expense of creating buffers against a good deal of it. Net exposures are, though, only as good as the hedges on which they are premised.
Here lies the heart of the leverage controversy. If you don’t believe in netting, then you can’t agree to adjust assets based on it; if you do, it’s an obvious refinement. Why not believe in netting? In the past, this might have made sense since counterparties could well lack capital to honor their risk-mitigation commitments. Post all the reforms, though, this is far less likely – after all, why mandate huge amounts of collateral, central clearing, and the like if it doesn’t support counterparty resilience?
To make rules make sense means reading the book as a whole, not each rule in its own little missile silo. With all the new rules reinforcing counterparty credibility, netting is a real and meaningful way for banks to reduce risk. One would think that regulators would want not only to recognize it, but indeed also to encourage it. If leverage reflects robust netting, it creates a strong incentive for banks to hedge – if it doesn’t, it gives banks a strong capital incentive to go out naked.
Water-down or “lax?” Recognizing netting doesn’t eviscerate leverage. Instead, it makes it not just an accurate reflection of risk versus nominal assets, but also a positive force for safer banking. Still, this is a hard point to explain to audiences deeply skeptical of bank arguments, especially complex ones.
Time to mount up, not hide out, though. If big banks expect critics like Sen. Brown or FDIC Vice Chairman Hoenig to back down or be out-gunned on gross leverage once Basel finalizes a netted standard, they will be sorely surprised. Better policy-maker and opinion-leader understanding on this point is critical if the new Basel rule is to carry over into a sensible U. S. leverage standard.