I updated this post, as discussions on the leverage ratio still suffer from a poor understanding of this solvency measure. See my post on this odd proposal by three Dutch professors, who basically want to turn back time to the Basel II (not III) era, and allow banks to borrow money to increase their capital ratios.

This post presents some eye-openers on the leverage ratio and Basel III solvency ratios. Discussions on the leverage ratio have gained momentum. However, the discussions on this measure of solvency sometimes lack rigour, which leads to poor inferences.

Small changes in the amount of capital held by a bank can have significant effects on a bank’s business. Therefore it is important to use consistent definitions and measure data correctly. I will focus on Basel III, as this standard is being implemented, and, apparently not always well understood.

So, time to open your eyes on the following points:

The numerator is not a kitchen sink. Capital forms the numerator of any solvency ratio, including the leverage ratio. With ratios of around 5% or lower, it makes a difference how you define a numerator.

Unfortunately, discussions on the numerator lack rigour. For example, some commentators assume that a regulatory leverage ratio exists with Equity as numerator and Total accounting Assets as denominator. Unfortunately, Basel III does not define any solvency ratio as Equity divided by Total accounting Assets, nor do national supervisors use such a definition.

Instead, Basel III defines two distinct and well-defined ratios, the Common Equity Tier 1 ratio and the leverage ratio.

The distinction between these two ratios is very important: under Basel III rules, a bank can meet a leverage ratio requirement of 30% with 10% Common Equity Tier 1 and 20% hybrid securities. This is like having a mortgage on your home where you borrow two thirds of the down-payment. If banks don’t like you to borrow for your down-payment, why would you allow banks to do it? Exactly, it is where we don’t want to end up. We learned from the crisis that hybrid securities failed abysmally in their role of capital – like banks figured out that it is a bad idea to offer a mortgage to home buyers who borrowed money for their down payments. Hybrids acted like debt, thus not absorbing the losses they promised to absorb.

It is for this reason that calls for higher bank solvency ratios should focus on Common Equity Tier 1 only. As hybrids are accidents waiting to happen, please let go of the assumption that kitchen sink equity is bank capital of the highest quality. It is not.

Therefore, to avoid ambiguity, why not use the Basel III definitions too.

1. the Common Equity Tier 1 ratio, or CET1 ratio: the numerator of this ratio is predominantly accounting equity or book equity, including reserves and other comprehensive income; adjusted for prudentially weak accounting items such as Goodwill and Deferred Tax Assets. Common Equity Tier 1, the numerator, is capital of the highest quality. We all want banks to have high levels of this type of capital. (The Common Equity Tier 1 ratio divides its numerator by risk-weighted assets, which are asset values corrected for a level of riskiness.)
2. the leverage ratio. Here, the numerator is Common Equity Tier 1 plus subordinated, debt-like, securities. These securities are really weak bank capital. They are not even perpetual as they can be repaid within 5 years. Banks are fascinated by these hybrids, even though they tend to end in tears; see my post on Deutsche Bank’s recent Tier 1 hybrid perils. (The denominator of the leverage ratio is close to audited accounting total assets.)

Any person discussing the leverage ratio should figure out which of these two definitions apply. Those who support a leverage ratio of 10% may deliberately chose to favour a ratio that consist 5%/5% of CET1 / Hybrids, thus weakening the capital structure of a bank.

A macro-analysis of solvency may be inapt. Good data on bank solvency ratios is not available for many countries outside the US. But many jurisdictions do keep records of macro data.

Though it is tempting to use macro-data to analyse banks, it can lead to incorrect inferences. See the post of Robin Fransman on Pieria. His post relies on the the fact that a few big banks drive macro data: a macro-focus coincides with the interests of big banks. For example, I divided the total amount of Tier 1 capital of U.S. banks on December 31, 2012 by the total amount of bank assets, with a macro leverage ratio of 8% as a result. This looks worryingly low, and may call for action and new policies. But, the meagre 8% is driven by a few big and poorly capitalized banks. So when I measured the mean leverage for all banks in my sample by adding up their leverage ratios and dividing the sum by the number of banks, the ratio increases to 14%. This fairly good result is driven by many small and well-capitalized banks.

Given that a few big banks drive the macro data, and often individual banks cause trouble, one may think again before using a macro-approach.

The leverage ratio is a Topsy-Turvy measure. One would expect the leverage ratio to increase with indebtedness. However, this is not the case in the banking industry. It’s the definition. With capital as the numerator and assets as the denominator, the leverage ratio instead decreases with indebtedness. Highly levered banks sometimes have leverage ratios of 2%, which is bad. Note, for bankers, this point may be a no-brainer, but the inverse use of leverage can be confusing. Moreover, the statistical properties of denominators are not great, which frustrates measurement, analysis, and policy making.

As an illustration of this last point, read this speech of Stefan Ingves of the Basel Committee, who struggles with denominator of the solvency ratios. He basically asks banks to figure out how to deal with the denominators.

The denominators of the ratios are managed. Both ratios have in common that they incentivise banks to lower them. The Common Equity Tier 1 ratio incentivises banks to holds assets with low risk weights, even though the real risks attached to these assets are high. A telling example is Greek sovereign bonds. Another example is banks in the Netherlands who invested heaps of money in assets with a low risk classification, e.g. residential mortgages. These banks now go at great lengths to defend their addition to risk-weighted leverage ratios.

With a zero risk-weight, banks hold them to increase reported capital ratios, even though these bonds are risky. A different story applies to securitizations, they may receive a 1250% risk weight, which is punitively harsh for well-capitalized banks. De 1250% risk weight assumes an 8% capital ratio. Banks with that ratio should allocate precisely as much capital as held in the assets. However, for better capitalized banks, the 1250% forces them to allocate more capital than they hold in the form of securitized assets.

On the other hand, the leverage ratio incentivises banks to keep all types of assets off-balance, also the safer assets.

Neither of both ratios are perfect. Using both ratios may therefore have merit.