Comment on BoE´s Sir Jon Cunliffe´s speech, July 17, 2014, on the leverage ratio in bank regulations.

Sir Jon Cunliffe of the Bank of England, Deputy Governor Financial Stability, Member of the Monetary Policy Committee, Member of the Financial Policy Committee, Member of the Prudential Regulatory Authority Board gave a speech on July 17 on the role of the leverage ratio. In it he states: 

“The underlying principle of the Basel 3 risk-weighted capital standards – that a bank’s capital should take account of the riskiness of its assets – remains valid. But it is not enough. Concerns about the vulnerability of risk-weights to ‘model risk’ call for an alternative, simpler lens for measuring bank capital adequacy – one that is not reliant on large numbers of models. 

This is the rationale behind the so-called ‘leverage ratio’ – a simple unweighted ratio of bank’s equity to a measure of their total un-risk-weighted exposures. 

By itself, of course, such a measure would mean banks’ capital was insensitive to risk. For any given level of capital, it would encourage banks to load up on risky assets. 

But alongside the risk-based approach, as an alternative way of measuring capital adequacy, it guards against model risk. This in turn makes the overall capital adequacy framework more robust. 

… bank capital adequacy is subject to different types of risks. It needs to be seen through a variety of lenses. Measuring bank capital in relation to the riskiness of assets guards against banks not taking sufficient account of asset risk. Using a leverage ratio guards against the inescapable weaknesses in banks’ ability to model risk. 

Whether the leverage ratio or the risk weighted capital ratio bites on any individual bank will depend on what are the greatest risks facing that bank” 

And those assertions contain some important impreciseness and problems on which I must comment. 

First “that a bank’s capital should take account of the riskiness of its assets – remains valid… Measuring bank capital in relation to the riskiness of assets guards against banks not taking sufficient account of asset risk” 

Absolutely not so! A banks capital should take account of the risk of the bank, which though related to the risk of its assets, is something quite different from the risk of its assets. For instance a bank that has an overconcentration in some few very absolutely safe assets might be infinitely more risky than a bank that has a great diversified exposure to risky assets. The most unfortunate part of current capital requirements is that they are portfolio invariant. 

Second “a leverage ratio guards against the inescapable weaknesses in banks’ ability to model risk”.

Not just so! Models are based on expected risks, while leverage ratios should cover primarily for unexpected risks, and “model risks”, the risk of models sometimes not being correct, has even a lot of being an expected risk. And so in this respect the leverage ratio is to cover for much more unknowns than model risk.

Third “Whether the leverage ratio or the risk weighted capital ratio bites on any individual bank will depend on what are the greatest risks facing that bank”

Not so! What will bite an individual bank has nothing to do with risks, and all to do with its current capital position. If a bank is under the leverage ratio then that is its binding constraint, and if over it, the risk-weighted capital is.

And here is where I need to express my most serious concern with the leverage ratio, and that is that as it increases the floor of minimum capital, it will intensify the distortions produced by risk-weighing. Do you remember the movie the “Drowning pool” where Paul Newman and Joanne Woodward are pressured against the ceiling by an increasing level of water? Precisely that way!

Conclusion: I want a leverage ratio 6-8% but not in the company of the so odiously distorting risk-weights.