Matt Levine writes:  Ever since about mid 2008, when everyone had a massive panic about bank capital, there has been a community of people who wanted to ignore the Basel Committee on Banking Supervision, and their “Tier One Ratio” (based on equity divided by “risk weighted assets” or RWA). Instead, people like Anat Admati or Andy Haldane have suggested that we should just take the equity in the balance sheet, and divide it by the assets to get a “leverage ratio” without any of this complicated risk weighting stuff.

Are they right? In my opinion, yes to the extent that they want to look at the leverage ratio, but very much no to the extent that they want to get rid of risk weighting. It’s true that risk weighted assets and the Basel framework have gone badly wrong in the past and even contributed to some failures. But to take that as a reason for throwing the whole system away is not helpful.

MYTH — Leverage is a “simple” and objective calculation

FACT — Only if you think that calculating a bank balance sheet is simple and objective

MYTH — Leverage is a more conservative standard than RWA

FACT — Unless you make major adjustments to the “simple” leverage ratio, it misses whole categories of risk.

MYTH — Leverage ratios can’t be “gamed” by the banks.

FACT — Leverage ratios are very often gamed

MYTH — Risk weighted asset calculations are always fudged and faked by the banks

FACT — No evidence has been found of this despite a dozen studies

There are two, related, legitimate reasons why the leverage ratio is a big step forward.

First, it acts as a checksum. Most of the things that a bank might do to fool the risk-weighted asset ratio would have the effect of making the balance sheet bigger and the leverage ratio worse. Most of the things that a bank might do to fool the leverage ratio would have the effect of piling up tail risks and making the risk-weighted assets ratio worse. It’s comparatively difficult to think of measures which can fool both ratios at the same time.

Second, and related to this, it helps to avoid “corner solutions”. What you don’t ever want to do in banking is to create the impression that a particular line of business has a zero capital requirement.  If you have more than one ratio, you have much less chance that any activity is going to get a very low capital charge.

Leverages are useful but not simple.  Leveraging

No Simple Answers