As clients know, a major theme in recent regulator pronouncements is a demand for less leverage to ensure financial institutions are better insulated from the next storm. However, as we look at the regulators, we’re struck by one little-noticed feature of their own balance sheets. If you think banks are highly-leveraged, take a look at the FDIC and FRB – they make banks look like pikers. Thus, as we all think about curing procyclicality, we’ll need to fix more than the bank’s capital structure. We’ll also need to do a lot to deleverage the banking system’s backstops so future crises don’t force even larger taxpayer bail-outs.
First, though, to what the regulators’ leverage is and why it’s so high. The FDIC’s statutory leverage ratio – the so-called designated reserve ratio (DRR) – was set in 1991 at 1.25 percent. Why 1.25 percent? Was it careful calculation of the amount of bank premiums needed in a reserve fund to reflect an actuarial assessment of risk to the Deposit Insurance Fund? Not exactly. The DRR was set in 1991 based in large part on what Congress would pass following a long battle between the FDIC and the banking industry. The DRR is in fact simply a best guess. In fact, it’s not even that because best had little to do with the debate at the time. Instead, it’s just a guess, one since buttressed by a “risk-based” premium schedule based on even more back-of-the-envelope, compromise-driven determinations.
Of course, the FDIC – like some of its charges – has sadly dropped into the negative capital range. Let’s hope the FRB doesn’t follow suit. Today, Chairman Bernanke gave a speech detailing what’s in the Fed’s $2.14 Trillion on-balance sheet book. In the new-found spirit of transparency forced on the Fed by its critics, the Bernanke speech provides a window into what the Fed holds and how risky some of it is. The crisis has of course forced the Fed far afield from its traditional portfolio of Treasury securities, with the Board now holding billions in obligations ranging from agency paper to TALF loans and all the stuff it was forced to take from AIG and Bear Stearns. Backing this up is about $50 billion in capital, meaning the Fed clocks in at a leverage ratio of 2.4 percent.
To be sure, the FDIC and FRB numbers aren’t exactly comparable. The FDIC’s DRR is essentially an off-balance sheet capital ratio because the FDIC doesn’t hold bank deposits per se – it guarantees them. On a simple on-balance sheet basis, the FDIC is thus far less leveraged than the Fed, where the number is calculated by subtracting assets from liabilities. If we add what the Fed implicitly backs to what’s on its books, the “Reserve” in Federal Reserve gets more than a bit iffy.
Is it fair to compare bank leverage to that at the FDIC or FRB? In one sense no, because of course both agencies are not only different from banks, but also from each other. But, we think it’s still more than relevant to look at these leverage ratios as an initial step in contemplating the procyclicality of regulatory policy, which is at least as problematic at the regulators as it is at the banks they govern. If the FDIC and FRB are independently capitalized only to do their jobs under the sunniest of circumstances, they join the list of “systemic-risk” institutions that need to think about higher reserves to ensure a robust ability to function under stress.