Monday, August 7, 2017

Paul H. Kupiec — The major flaw in big banks' argument against the leverage ratio

Excessive leverage was a primary cause of the financial crisis, and yet big banks and even some government officials appear eager to relax rules that limit leverage at the largest U.S. financial institutions. But banks’ argument for why such reform is necessary doesn’t hold water.
Large banks say the risk-insensitive nature of the Basel III Supplemental Leverage Ratio (SLR) restricts market liquidity by increasing banks’ cost of holding so-called “safe” securities and derivatives for market-making activities. A proposed change to the leverage ratio would remove those assets from the SLR calculation. But the proposed change would allow more leverage which could amplify the alleged liquidity problem....
The Treasury’s solution is to deduct the institutions’ holding of central bank reserves, U.S. Treasury securities and initial margin for centrally cleared derivatives, from the SLR’s total leverage exposure. This is equivalent to risk-weighting the SLR components and setting some weights to zero.
Using regulatory data, my estimates suggest that these changes could increase the SLR reported by some G-SIBs by more than 1.5 percentage points — or the equivalent of gaining roughly $40 billion in new Tier 1 capital — just by making a few “minor” technical changes to the SLR calculation.

Make no mistake, the Treasury’s proposed SLR rule change would allow G-SIBs to increase their leverage. And this is why the large banks’ argument in favor of changing the SLR is so thin.…
The Treasury’s proposed changes to the SLR calculation will not restore the incentive for banks to get back into safe market-making activities.
Much more in the post, but the discussion here at MNE has been focused on the bank reserves, the leverage ratio, and the Treasury proposal. Kupiec argues that it's necessary to look at the big picture.

American Banker
The major flaw in big banks' argument against the leverage ratio
Paul H. Kupiec | resident scholar at the American Enterprise Institute

12 comments:

Matt Franko said...

"Excessive leverage was a primary cause of the financial crisis,"

Yeah it was the excessive leverage caused by the Fed forcing like 600b of non risk reserve assets onto the bank balance sheets in like a month in Sep 2008. LOL!

Tom Hickey said...

it was the excessive leverage caused by the Fed forcing like 600b of non risk reserve assets onto the bank balance sheets in like a month in Sep 2008

IIRC, the reason was transferring bank's dodgy assets to the Fed's balance sheet. This replaced those dodgy assets with bank reserve banks that were 100% safe.

This was done to keep the banks solvent to avoid the legal requirement for putting insolvent banks into resolution. This was when the accounting rule was mark to market. This rule was changed to mark to model in May 2009, again IIRC.

Equities immediately blew off and never looked back. The Fed had signaled that it had their back.

Matt Franko said...

Well just look at the H41 and see what the Fed bought... it was all govt securities...

THEN they had to do the TARP ....

Step 1. Fed buys USTs and creates $1T of non-risk assets on bank balance sheets.

Step 2. Watch system collapse in response as banks have no capital to comply with the influx of all the new non risk assets ...

Step 3. Bailout the banks with TARP...

Matt Franko said...

" or the equivalent of gaining roughly $40 billion in new Tier 1 capital "

My estimate is much more than that...

Ralph Musgrave said...

Another flaw in leverage - any degree of leverage - is that it enables private banks to print money, as Milton Friedman explained. And letting private banks print or "create" money is a subsidy of those banks, just as letting people with printing presses turn out their own $100 bills is a subsidy of those people paid for by the community at large.

André said...

Well, I agree with banks in regards to the lack of risk sensitivity in the leverage ratio.

I mean, if $10 of a risk free asset requires the exact same capital as $10 of a risky asset, banks will tend to buy the risky asset. They will avoid the risk free asset, buying the minimum amount possible. And that would be dangerous. It's already a problem present in today's bad calibrations in the risk weighed capital requirements.

If more capital is required for the risky assets, than this asset is being penalized. That's fair.

I don't think it's healthy to require capital for treasuries, for example.

I don't know much about US banking, but in other parts of the world the leverage ratio is not binding (while the traditional risk weighed capital ratio is binding). So any changes will actually not bring much impact...

Matt Franko said...

Well they have about 2.5T of Deposits at the Fed and another 2.5T of govt securities ... if they are running an internal LR of .1 against this and they get the rule change then that theoretically eliminates the need for current 500B of regulatory capital... one year of after tax earnings for the SP500 is about $1T....

André said...

Couldn't understand what you said...

Matt Franko said...

Non-risk assets: $5T

they have maybe 500B of capital against these non-risk assets... they get the reg mod and they don't have to reserve this 500b any more... what are they going to do with it?

Tom Hickey said...

Distribute it in dividends and use it for stock buybacks.

Banks lend to creditworthy applicants that are willing to accept the banks' terms, not due to either bank leverage or capital.

André said...

If leverage ratio is bot binding, you can lower it to whatever level you want. The risk weighed capital requirements will be binding and the banks won't be able to distribute dividends.

If the leverage ratio is binding, that's because banks are using the advanced capital requirements approach (Internal Ratings Based) and so they are gaming the rules and making the risk based capital requirements ridiculously low. That's when the leverage ratio becomes the capital limit.

The solution is not to raise the risk insensitive leverage ratio requirement. The solution is to promote the standardized risk weighed capital requirements and prohibit the advanced approach.

Matt Franko said...

How much do they need to meet the CAR ratio against the risk assets currently?

Vs how much do they need to meet the SLR ratio against ALL assets currently ?

Subtract those two numbers.... see what you get...