Ben Chu: Why banks must come clean about leverage

Economic Outlook: The banks' desire to protect high leverage is founded on self interest, not concern for the economy
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The Independent Online

No government that considers itself fiscally prudent can afford to ignore the behaviour of its domestic banks: that is one of the central lessons from the financial chaos of recent years.

The Irish government ran a budget surplus before the 2008 meltdown and was congratulated for its fiscal discipline. By 2010 the same government was running a deficit of 30 per cent of GDP and had been forced to apply for an international bailout. That was the price the authorities in Dublin paid for rescuing collapsed banks, which had been allowed to run riot in the boom.

Ireland is only an extreme manifestation of a trend across much of the developed world. Since 2008 banks across Europe and America, which made ruinous investments, had to be propped up by governments. As a result of the economic dislocation brought on by the bursting of the lending bubbles these banks had blown up, sovereign debt levels are set to rocket in several advanced countries, Britain included. And, of course, now the eurozone maelstrom – itself in large degree due to recklessness by large banks – threatens to spark another surge in sovereign indebtedness. Banking regulation is fiscal discipline and fiscal discipline is banking regulation. They are two sides of the same coin.

So how do we make banks safer and stop them hurting taxpayers? Britain's new super regulator, the Financial Policy Committee, hinted at its thinking last week when it suggested banks should publish details of their leverage, not just their capital ratios.

The difference between leverage and capital is unlikely to quicken most pulses. But it should; therein lies one way banks disguise the irresponsible risks they are running and the huge costs they can impose on taxpayers. A bank's capital ratio refers to the size of its equity buffer – the bit supposed to absorb losses when loans go bad – in relation to its holdings of "risk weighted" assets. It is the standard measure regulators use to judge a bank's safety. A bank with a capital ratio of around 10 per cent it is usually considered sound.

But the system of assigning varying "risk weights" to different assets, introduced by the 1988 Basel Accords – an attempt by regulators to set standard capital rules for global banks – is dubious, complex and open to abuse. Banks are able to treat most sovereign bonds as entirely safe, requiring little or no capital to be held against them.

So, at one time, a Greek sovereign bond was seen as unlikely to default as a German sovereign bond.

Another flaw in the system is a reliance on the judgement of credit rating agencies. Under Basel rules, banks do not need to hold much capital against AAA rated securities. In boom years, high-yielding securitised US sub-prime mortgages were given just such a risk-free stamp by credit rating agencies. This is one reason why banks' balance sheets were full of these toxic assets in 2008. But the most glaring deficiency is that banks have leeway under the Basel rules to decide how risky their own assets are.

A leverage measure, by contrast, ignores risk weights altogether and exposes the simple relationship between a bank's capital cushion and its total assets, no matter what those assets are. So if a bank has £100bn in equity and £1 trillion in assets it has leverage of 10. A bank with £50bn in capital and assets of £1 trillion has leverage of 20. Some analysts argue that a simple leverage ratio is a better indication of a bank's safety than capital ratio, manipulated and misleading as that figure often is.

Andy Haldane, the Bank of England's executive director of financial stability, has produced research showing how leveraged three of the UK's largest banks were going into the 2008 crisis and how they fared in the crisis.

The table shows Barclays' capital base was leveraged around 39 times in 2007 and Royal Bank of Scotland 31 times. Both had to announce huge asset write-downs in the boom. Barclays wiped out 56 per cent of its pre-crisis equity and RBS lost 32.6 per cent and was rescued by the Government.

HSBC had a fairly conservative leverage of 21.3 and its losses in the bust were only 7.3 per cent of equity. It is also striking how quickly leverage ratios at Barclays and RBS were rising before the bust. Warning bells should have been ringing. These lessons are still to be learned by regulators. The Franco-Belgian bank, Dexia, was judged sound by the European Banking Authority in July, with capital levels of 12 per cent. But in October Dexia went bust and had to be rescued. Regulators should probably have paid closer attention to Dexia's leverage – an astonishing 60.

Disclosure is one thing – and useful to potential investors who are unsure if a bank is sound. But what about official intervention to limit leverage? Some regulators are increasingly inclined to the view that a simple cap would be a better way to ensure banking safety than the complicated "ring-fencing" retail bank recommended by the Independent Commission on Banking this year. Could the Financial Policy Committee's instruction for banks to report their leverage levels be a prelude to the imposition of a hard cap?

If it does, expect banks to offer fierce resistance. They will say leverage caps hinder their ability to lend to those needing credit, thus hurting the economy, and will complain that a cap would put them at a disadvantage to highly leveraged European banks. These costs are exaggerated and easily outweighed by the wider benefits of a banking system less prone to boom and bust.

Moreover, the banks' desire to protect high leverage is founded on self-interest, rather than concern for the economy. Managements can produce impressive profits by running a large balance sheet of assets on a small capital base. The "returns on equity" (ROE) that banks generated in the boom years were high – often above 20 per cent. Remuneration packages of executives tend to be linked to ROE. A cap on leverage would impede their ability to deliver returns on this scale and their ability to pay themselves huge bonuses.

Executives will not embrace leverage caps for the reason turkeys do not vote for Christmas. But why should the rest of us care what the turkeys think? It is us, rather than them, who bear the risk if their leveraged bets go wrong.