Since the adoption of Basel I, bank regulators have let banks hide the increased use of leverage on and off their balance sheets through the concept of risk weighting the bank's assets. This was done so that banks could generate a competitive return on equity.
The financial crisis and the sovereign debt crisis have shown that risk weighting the assets is fundamentally flawed. Both AAA-rated securities and sovereign debt were shown to have far greater risk than the Basel capital agreements assigned them.
Executives at some U.K. banks are bristling at a new requirement to reveal a simple measure of their risk that regulators hope will help restore investor confidence and make the financial system stronger.Regular readers know that restoring investor confidence is a function of transparency and ending disclosure requirements that leave banks resembling "black boxes".
Will reduced leverage make the financial system stronger?
That depends on how the banks respond and change the composition of their exposures. It could make the system stronger if the banks shed high risk assets. It could make the system much weaker if the banks shed low risk assets.
The only thing that is certain is that banks will optimize their asset mix to generate the highest return on equity consistent with achieving the capital ratios set by regulators.
Starting early next year, British banks will have to disclose the amount of equity they hold as a percentage of their total assets, a basic measure of their financial health known as a leverage ratio, some two years ahead of their global counterparts.
Unlike current methods to assess the banks' ability to absorb losses, the leverage ratio doesn't include any adjustments to reflect the varying degrees of safety or risk on customer loans, cash and bonds.
The measure has gained favor with international rule makers since the financial crisis, as a backstop against banks engaging in rampant lending or asset-hoarding that can threaten economic stability.
In the U.K., authorities say that providing the ratio should give investors a fuller picture of banks' health.....
Bank executives complain that leverage ratios now may be misleading, since they are based on definitions of assets and equity that are still being completed by international regulators. ....
At worst, some executives fear the headline numbers could spook investors into shunning banks' stocks and bonds and pressure the banks to shrink their loan books even as the U.K. economy struggles to grow....
The ratios are designed to put a floor in the financial system when banks and regulators fail to adequately identify risks.
Bank of Canada Governor Mark Carney, who from next year will head the Bank of England and its supervision of U.K. banks, has said Canada's leverage limits, which are set bank by bank, meant its lenders didn't load up on the toxic debt that sank banks in the U.K. and other countries in the crisis.Even with the leverage ratios, banks will still be capable of blowing themselves and the financial system up.
Leverage was a whole lot lower in the 1980s and banks effectively blew up the system with Loans to Less Developed Countries and then commercial real estate loans.
Investors increasingly have become disillusioned by the ways banks value their assets and how the forecast potential loan losses, particularly when banks assign different "risk weights" to the same assets.The only way to address this disillusionment is by requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.
Then investors can independently assess the risk of and value each bank.