The Biggest Banking Scandal this Summer (Hint: It’s not LIBOR)
While corporate news media speculate on just how many luxury cars Mitt Romney owns or whether Chief Justice John Roberts is a Subaru-driving, soy-loving, closet-liberal, they’re missing what is arguably the most decisive political story of the summer: regulatory capital “reform.
Just over a month ago the Federal Reserve quietly released a proposal to implement Basel III, an international agreement signed by twenty-seven nations aimed at ensuring the global economy’s resilience against financial disintegration. The directive, drafted by a cadre of central bank representatives and national regulators known collectively as the Basel Committee on Banking Supervision, devised rules focused on both the type and amount of capital banks must hold to protect themselves against potential losses.
Since the first iteration of the Basel Accords in 1988 (Basel I), one of the most critical features of the international agreement has been the leverage ratio requirement. Financial leverage refers to the relationship, often expressed as a percentage, between the money a bank borrows and the capital (both liquid and long-term) it has available to it. More simply, leverage for a bank is essentially the amount of equity a bank possesses relative to its assets; the leverage rate is defined as the ratio of total assets to equity. That is, leverage is a measure of how much a firm borrows relative to its total assets and low leverage rates often indicate the strength and stability of a financial institution.
Prior to 2004 when the Securities and Exchange Commission (SEC) relaxed leverage requirements on lending institutions, most depository banks had leverage ratios of around 10:1.
But beginning in 2013 the Federal Reserve will require that banks with $500 million or more in assets (Tier 1 institutions) adhere to a leverage ratio of 3 percent, or 33:1. What exactly does this mean? A leverage ratio of 33:1 will limit banks from lending more than 33 times their capital. But isn’t this roughly the same leverage ratio held by Lehman Brothers, Merrill Lynch, and Bear Sterns at the time of their collapse in 2008?
The high degree of leverage that each of these banks then carried—the ratio of total assets to shareholder equity—made them increasingly vulnerable to deteriorating market conditions. To be fair, the advantage of high leverage is that it helps banks acquire more money with which to invest or to loan to consumers. The disadvantage of high leverage, however, is that it makes financial firms exceedingly fragile, inflexible, and unresponsive to quickly changing markets. If there is a bank-run on an institution with a high leverage ratio of, say, 33:1, the lender will almost assuredly slip into insolvency.
The third Basel accord, which is to be phased in incrementally from 2013 through 2019, does increase top-quality capital requirements equivalent to 7 percent of their risk-bearing assets, but its regulatory advances are undermined by an unapologetically low minimal leverage ratio requirement.
Tighter international restrictions on bank leverage would certainly afford the global economy better protection. The Federal Reserve invites comment on the Basel III capital reforms from now until September 7th. This is a vital opportunity to tell the Federal Reserve Board that more prudent regulatory provisions on banks are necessary to ensure the safety of consumer deposits and the strength and stability of our economy. Five minutes of your time could go a long way.
You can submit your comments to the Federal Reserve