Cost of Deleverage
How BIII 3% leverage ratio is reshaping global banking
A short note on what’s going on in banking system in the light of BCBS late June announcement on how required 3% Leverage Ratio will be calculated when mandatory disclosure comes into effect in 2015.
Quick reminder what does 3% leverage means in real and simple terms: if Bank’s assets may not exceed 33 times its equity (and BCBS announced that it is going to calculate total equity towards total exposure), a 3% write down in its asset value — would wipe out its entire capital.
European banks are particularly likely to be hit hard as they tend to run much bigger balance sheets than US banks who sell-off pools of mortgages to off-balance-sheet vehicles. The Leverage is being fiercely attacked by the bank lobby arguing that diversity of risks taken and their idiosyncratic nature varying from bank-to-bank makes such crude measure as Leverage Ratio not fit for purpose. Moreover, they are arguing that such measure undermines Risk Weighting approach towards capital adequacy. Bank’s position is very reasonable, though extremely self-centred. On the other hand regulators seem to be more and more convinced that risk weighting approach is flawed when it comes to biggest banking institutions who effectively exploit loopholes in the approach (consider Deutsche Bank situation). Obviously we have two contradicting arguments and goals on hans. If banks says that LR undermines capital adequacy regulations, BCBS says that LR removes loopholes from the capital adequacy portion of BIII.
The biggest banking institutions in fact are the ones to suffer the most from leverage ratio approach. As smaller institutions haven’t got enough market power to access cheap debt.
European banks already started shedding their assets in order to reach the 3% capital ratio. Barclays and DB are among the first to take swift action. (Reminder under current BCBS initiative LR requirement will come into force in 2018 and disclosure shall start in 2015. However, UK and US regulators are moving faster).
I was asked how much is it likely to cost for banks to implement the 3% leverage ratio? After giving some though I realised that it is very hard to put a number as with all the fuss in the market, all the lobbying and all the regulatory populism its is hard to grasp what are the real costs of this micro-prudential regulatory tool.
For example Barclays and DB have already shed assets equal to EUR 400 Bill. among them and are using this as an illustration that real economy is going to suffer as banks are aggressively cutting their balance sheet and not lending for economic recovery. On the other hand regulators are saying that a long-term effect is much more important as after the lobbying ceases and stability comes to the market — Banks will simply start raising fresh equity to boost their buffer and stop irresponsible balance-sheet boosting and this in turn will bring financial stability, which is of benefit to the banking system itself. In such way downside costs would be avoided and in the long-run there would be no negative effect to the real economy. However, in contrast DB has announced that shrinking balance sheet by approx. EUR 200 — 300 Bill. will reduce profitability by around EUR 300 mill. and this in turn means less room to use retained earnings, more expensive equity and obstacles for effectively serving main banking function — channeling more for economic growth.
Bottom line — an open war is going on at the moment in the market. However, this does not surprise me at all — it has been like that since 2007 with any piece of legislation. Which in the long run has been embraced after all. However, regulators need to have a big-picture approach, especially on the issue how risk weighting and leverage ratio work together? What are the possible unintended consequences?
One particular remark from the banking industry struck me: banks are coming to terms with the fact that exploitation of risk weighting loopholes will not be tolerated after all and are proposing to remove those loopholes instead of imposing new regulation — like leverage ratio, to plug the holes. This illustrates my point that risk weighting approach is not fit for purpose for the big banking institutions, at least in the form it is imposed at the moment. Of course higher capital requirements (significantly as proposed by Lord Turner); review of Internal Risk Approach models (i.e. regulators better understanding risks instead of outsourcing risk assessments); return to standardised risk weighting model might help to remove exploitation possibilities. However, at least at the moment I am kind of convinced about benefits of introducing leverage ratio restrictions (not yet sure if 3% should be the number though).
Considering all of this I think that biggest costs of reducing leverage might be emergence of unintended consequences that need to be addressed: piling more risky assets on balance sheet to keep the profitability going; reduced lending to the real economy and inhibited economic recovery; abuse of originate-to-distribute model… As per banking institutions — it will take some work to balance their balance sheet and make them work with reduced assets and increased equity. Main argument is that this will affect their profitability as they were used to before the financial crisis. However this is arguable. Some scholars argue that the only profitability that is going to be hit — is bankers’ themselve (reduced bonuses; balooning remunerations; excesive incentive systems). The argument goes: lower profitability means more financial stability and more stability means less risk-premium from investors acquiring banks’ equity. So financial system benefits; investor benefit; economy benefits. And they will definitely need to raise fresh equity (also to meet capital adequacy) which may not be cheap in the face of falling profitability.
[For the discusion on profitability and deleveraging see Mr. Robert Jenkins (the most prominent scholar fiercely promoting Deleveraging) Stumbling Towards Stability, in the Financial News, 14 January 2013]
Ghosts of capital adequacy strike again! Deutsche Bank 4 months ago, after raising fresh capital amounting to EUR 3 bill. boldly stated that now DB is among best capitalised banks in the world. However, market data shows quite an opposite. DB’s shares have lost around 7,3% since June (fresh capital being raised around May and June). And this is not because of shareholder dilution. Markets were praising injection of fresh capital being frightened by constant attack from regulators (Barclays being the only other peer suffering this kind of attention on capital issues). This is because markets are loosing trust in “adjusted balance-sheet” concept. Not only because of “risk-weighting” but also because of all the nasty things huge banking institutions can do with accounting when employing literally — army of accountants doing their thing under US accounting standards. As a result investors’ excitement quickly faded when instead of looking into “adjusted” balance sheet (which DB claims to be EUR 1.583 Trill) they looked at a crude measure of Leverage Ratio. Capital ratio calculations vary deeply among different banking institutions due to recent trend of “outsourcing” risk oversight and risk assessment to banks in-house (i.e. regulators giving a blind eye towards banks’ risks assessment model and praising efficiency of such system). Banks have gone great lengths to polish the way they conduct their risk assessments and risk weighting. Needless to say — crisis messed everything up and “risk adjusted balance-sheets” started lacking credibility due to the fact that it became clear that it is impossible to get good information how the adjustments were made (simply too much fact specific information is required to conduct even a simple analysis). The fact that banks were caught pant-less — struggling to spot, assess and value the risks they were exposed to even when facing existential questions (to go for bail-out or stand strong) did not help to attract investors’ trust.
When looking at Basel III requirements pertaining to Leverage Ratio (which will be phased in until 2015) investors come up with a figure more close to 2% leverage ratio (again: it means that loss of 2% on asset side — like non-performing loans/losses on derivative positions — which by the way stand at around 72 Trill (source unknown and untested for accuracy), would wipe-out entire capital). BIII not being too over-cautious put the Leverage Ration requirement at 3%. So a shortfall towards agreed measure of safe-capitalisation is in the area of 1%. Which is HUGE for a banking institution with “adjusted” balance sheet of 1,583 Trill. Please be reminded that Basel rules on leverage — were recently praised by banking industry to be in favor of the industry and do not represent genuine shot at making institutions safer (loads of reasons for that — but it will suffice to say that helping economic recovery and being afraid to inhibit fragile recovery in extremely volatile times is one of the main reasons providing for at least some lenience towards banking industry from regulators).
There are plenitude of other discussions stemming from this topic. Like DB’s exposure to LIBOR rigging; too fast and too rigid Balance-Sheet shrinking; banks shutting down the pipe of credit and therefore source for economic recovery; industry and regulators being in an unexplored area of what will happen if banks continue to shrink their balance-sheets and focus of not being too leveraged. However, what I am trying to say is that banking world seems to be coming back from being TOO DIFFICULT TO UNDERSTAND to being LESS DIFFICULT TO UNDERSTAND. Employment of leverage ratio was considered to be not deep enough to reflect “sophisticated business of banking”. But now the smart guys have left the room and more and more people seem to be becoming less scared to speak out that they can’t understand a hell about all this risk assessment and capitalisation. And yes — they truly could not understand what risks they were taking and how these risks should be reflected in overall bank soundness system. So I truly welcome moves towards more transparent system. And moves towards LESS LEVERAGED banking system!
[LAST UPDATED September 2013]
