Philipp M Hildebrand: Is Basel II enough? The benefits of a leverage ratio
Speech by Mr Philipp M Hildebrand, Vice-Chairman of the Governing Board of the Swiss
National Bank, at the Financial Markets Group Lecture, London School of Economics,
London, 15 December 2008.
* * *
1. Introduction
It is a pleasure to be at the London School of Economics this evening. I am very grateful to
Professor Goodhart for his generous invitation. As many of you know, Charles is a kind of
godfather to an entire generation of central bankers. His 1988 book, The Evolution of Central
Banks, remains a classic and is still required reading for aspiring central bankers. Let me
take this opportunity to thank Charles for tonight's wonderful platform and, more importantly,
for his long-standing contributions to the art, science, and craft of central banking.
Recurring financial crises have become a hallmark of the modern financial system. It would
seem that, every five years or so, a 100-year event destabilises the system. Moreover, each
crisis appears more violent than the previous one. With the current crisis as my showcase, I
will argue that excessively high leverage has been a key factor in making banks and
ultimately the financial system much more fragile and vulnerable than most observers,
regulators, or market participants ever imagined. Based on this diagnosis, I will argue in
favour of restricting the leverage of core financial institutions, i.e., banks. Needless to say,
banks have a tendency to oppose regulation. I will therefore discuss in some detail why
regulating banks' capital is necessary and why it promotes financial stability.
2. High leverage as a main cause of financial fragility
The Swiss economy is far from the epicentre of the current financial crisis. Yet, the two big
Swiss banks have been hit particularly hard by recent events. This is to a large extent the
consequence of their extraordinarily high leverage. For some years now, we have argued
that their high leverage makes them particularly vulnerable to extreme financial shocks.1
Looking at risk-based capital measures, the two large Swiss banks were among the
bestcapitalised large international banks in the world. Looking at simple leverage, however, these
institutions were among the worst-capitalised banks. With the benefit of hindsight, we clearly
should have put even greater emphasis on the risks of excessive leverage.
Excessive leverage is by no means a problem uniquely associated with the two big Swiss
banks. There is increasing international recognition that excessive leverage has been a
crucial contributing factor to the current crisis. In April, the Chairman of the Financial Stability
Forum (FSF), Governor Mario Draghi, summarised the view of the FSF when he said: "Our
conviction is that [...] institutions have accumulated a level of leverage that was both
misperceived and excessive."2 Gerald Corrigan argues that "leverage, in its many forms
clearly was a driving force in creating the market conditions that would trigger the crisis, just
as the inevitable de-leveraging on the downside of the cycle would severely amplify the
magnitude of the crisis."3 In a similar vein, the International Monetary Fund (IMF) stresses
that the dramatic deleveraging of financial institutions is exacerbating the downward spiral so
prevalent in the current crisis.4 Hence, by implication, the high starting levels of leverage are
a major source of the severe and ongoing adjustment problems. Finally, the leaders of the
G20 declared only last month that "excessive leverage" was a root cause of "vulnerabilities in
the system".5
Moreover, the problem of excessive leverage is not limited to the current crisis. It has been a
pivotal feature of most previous financial crises. John Galbraith, for instance, has carefully
documented the role of debt and leverage in crises going back to the 17th century.6 More
recently, the President's Working Group on Financial Markets concluded in 1999 that, "The
principal policy issue arising out of the events surrounding the near collapse of Long-Term
Capital Management is how to constrain excessive leverage."7
3. Is there a need for better regulation?
Assuming there is agreement that excessive leverage has been a major factor in past crises,
what ought to be done about it? An obvious response is to limit leverage. But is it really that
obvious? After all, some people would argue that regulation is at least partly to blame for
past crises.
Before I go any further, I want to clarify where I stand in the debate on regulation vs. free
markets - my ideological baggage, so to speak. I believe that free markets are the best
available mechanism to allocate resources and that they are ultimately the best way to
promote welfare and economic growth. Fundamentally, I am therefore wary of elaborate
efforts to interfere with the functioning of free, competitive markets. At the same time, it is
obvious to me that, under certain conditions, free markets produce inefficient outcomes. If
these market failures are apparent and important enough, they justify and indeed require
interference in the market mechanism. As Joseph Stiglitz put it, "Whenever there are
"externalities"- where the actions of an individual have impacts on others for which they do
not pay or for which they are not compensated - markets will not work well."8
In the real world of banking, potential market failures are particularly relevant. An important
market failure stems from the fact that banks enjoy the benefits of a safety net. Many
countries have explicit deposit insurance schemes, which limit depositors' losses. Moreover,
in almost every country there is some degree of implicit government protection for large
banks. In the current crisis, government protection has become manifest and explicit in the
form of the recent G7 and G20 communiqués. Most notably, in October the G7 finance
ministers and central bank governors declared unambiguously that they "agree to take
decisive action and use all available tools to support systemically important financial
institutions and prevent their failure."9 In other words, governments imply that large banks
are simply "too big to fail".
Clearly, there are benefits to banks having safety nets. But there are also serious costs. It is
a fact that the presence of insurance leads to less careful behaviour, otherwise known as
moral hazard. If you rent a fully insured car, you will likely exercise less care driving it.
Naturally, therefore, rental cars have a much shorter life span than non-rental cars. The
same reasoning applies to banks. No sane banker will intentionally manage his bank into
insolvency. But he or she has a lower incentive to avoid insolvency than if he were not
insured.
This sub-optimal level of caution is immediately apparent in banks' balance sheets: Banks
tend to hold very low levels of capital. In a cross-sectional comparison, banks have much
lower capital cushions than uninsured firms. On average, listed non-financial firms have
capital-to-asset ratios of 30 to 40 percent.10 In stark contrast, before the onset of the current
crisis, all of the world's top 50 banking institutions held, on average, only 4 percent of capital.
None of them held more than 8 percent.11
In short, banks have a preference for very high leverage. This highlights a fundamental
dilemma of capital regulation: Banks don't like it. Bankers will typically argue that high
leverage is beneficial or even necessary. Therefore, banks will naturally oppose any
regulation aimed at restricting leverage. I find this neither upsetting nor surprising. If
regulation is to be effective, we must expect it to impact on behaviour and restrict action. This
will solicit complaints. If it doesn't, regulation would, by definition, be superfluous.
4. From Basel I to Basel II
For all these reasons, I strongly support bank capital regulation that puts a meaningful limit
on banks' leverage. But what is the best way to restrict leverage? In an ideal world, we
would, of course, also want to take into account the riskiness of banks' assets.12 As you
know, banks can increase their risk not only by increasing their leverage but also by
increasing the riskiness of their assets. To compensate for differences in banks' assets, we
would ideally require banks with riskier assets to hold more capital. The Basel Committee on
Banking Supervision has embraced precisely such a risk-weighted approach. More risk,
more capital. If we lived in an ideal world, this simple principle would work well. By "ideal", I
mean a world in which risks can be observed by everybody and assessed precisely.
What has become abundantly clear in recent months is that we do not live in an ideal world.
Banks and the risks they incur are far from transparent. In fact, banks exist because of
asymmetries of information.13 A core function of banks is to "produce information". For
instance, banks screen potential borrowers. Furthermore, banks monitor ongoing lending
relationships. Without any asymmetries of information, banks would not be necessary, since
households could invest their savings directly or through mutual funds. Therefore, by
definition we cannot have banking with full transparency.14
Fortunately, banks are not totally opaque either. Some risks can be assessed more or less
readily. A US Treasury bill is clearly less risky than an unsecured loan to an obscure
software company. Therefore, capital requirements can at least partially be based on the
relative riskiness of various types of assets, even in our non-ideal world. "Basel I", the first
Basel Accord of 1988, introduced "risk buckets" for this purpose. For instance, loans received
a risk weight of 100%, government bonds a risk weight of 0%. "Basel II" - the revision of the
first Basel Accord - which is currently being implemented, tries to go beyond what were
perceived to be rather crude risk buckets. Under Basel II, risks are differentiated in more
detail. For example, a loan to a large, international AAA rated firm is typically not as risky as
a loan to a local restaurant.
While sensible, the higher risk sensitivity of Basel II comes at a price. First, banks and
supervisors alike incur significant operational costs to implement the new, highly complex
regulation. Second, but in my view more importantly, Basel II creates new risks: Risks about
risk assessments. I am tempted to call them the unknowable unknowns. Under Basel II, we
increase our dependence on risk models. What if we didn't pick the correct models? What if
the data used to calibrate these models turn out to be of poor quality? What if the models
were correct in the past, but the future is different? What if certain tail events simply cannot
be modelled? These are all important considerations that we have to keep in mind when we
interpret the risk figures from complex models. As it turns out, to view the model outputs as a
true representation of reality has proven to be a grave mistake. Furthermore, the increased
reliance on banks' internal models has rendered the job of supervisors extraordinarily
difficult. First, supervisors have to examine banks' exposures. Second, they have to evaluate
highly complex models. Third, they have to gauge the quality of the data that goes into the
computation of these models. To put it diplomatically, this constitutes a formidable task for
outsiders with limited resources.15
5. Strengthening Basel II: introducing a leverage ratio
So where does that leave us? Based on what we know and understand today, I would
suggest that risk-weighted capital requirements, broadly as proposed under Basel II,
probably remain the most rigorous way to address banks' tendencies to incur excessive risks
and, ultimately, to ensure adequate capital levels. However, we must address the serious
short-comings of the risk-weighted approach, which have become so powerfully manifest
during this crisis. What Basel II needs, therefore, is a safeguard to provide the financial
system with additional protection against the negative consequences of these short-comings.
I want to stress that a safeguard of this kind is needed in addition to the improvements to
Basel II that are currently under way as a result of the recent FSF Report to the G7 ministers
and governors.16 Which brings me back to the obvious and simple response to excessive
leverage: The imposition of a limit on banks' leverage as a complement to the risk-weighted
approach reflected in the current Basel framework.
The regulation of banks' leverage is usually referred to as a "leverage ratio". Specifically, the
idea is to set a lower limit to the capital-to-assets ratio of banks. Let me stress again that this
instrument is not meant to and should not replace Basel II. There is no reason to eliminate
the benefits of risk-weighted capital requirements. The leverage ratio should be applied as a
complement to the risk-weighted approach as reflected in the current Basel framework. That
means we would have two independent measures of capital adequacy. And banks would
have to meet a minimum requirement for both measures.
To some extent, such a capital regulatory framework is old news. Historically, capital
requirements in most countries took the form of simple leverage ratios. Risk-weighted
requirements were only introduced following the first Basel Accord of 1988. The
"oldfashioned" leverage ratios were replaced by "modern" risk-sensitive requirements. Some
countries, however, have maintained leverage ratios as essential elements of banking
regulation. Notable examples are the US and Canada. Despite being somewhat old news, I
am convinced that the introduction of a leverage ratio is fully compatible with the ongoing
efforts to strengthen banks' capital. We must not forget that Basel II aims to secure a
minimum level of capital. It's up to every bank and every national supervisor to exceed this
minimum. As the G20 has put it, "regulation is first and foremost the responsibility of national
regulators".17
6. The pros and cons of a leverage ratio
Let me now highlight the most important benefits of a leverage ratio. Equally, I would like to
address the most commonly expressed concerns about a leverage ratio.
Having a leverage ratio to complement risk-weighted capital requirements has many
advantages. Some of them I have already alluded to. Most significantly, a leverage ratio can
operate fully independently of any complex modelling assumptions and calibration
procedures. As such, it serves as a complementary instrument to risk-weighted requirements
when assessing banks' capital adequacy. This is of considerable value. During the recent
crisis those banks and supervisors, which took several instruments into account, including
volume limits and restrictions on asset growth, clearly performed better.18 More generally,
research has shown that risk-weighted capital ratios and leverage ratios contain
complementary information about banks' condition.19 Hence, by looking at both risk-weighted
capital ratios and leverage ratios, supervisors and banks can be expected to make better
judgments in a systematic way. Moreover, it is much more difficult for banks to arbitrage
around two capital ratios than around just one.
Can we say anything about the role of leverage ratios in the recent credit crisis? While a
rigorous analysis would reach beyond the scope of my comments today, it seems clear that
the leverage ratio has helped protect the US banking system from even greater calamity.
This is not necessarily because the leverage ratio encourages more prudent behaviour, but
because the leverage ratio ensures a minimal buffer to absorb the negative consequences of
imprudent behaviour. I leave it to your imagination what would have happened if the US
banks had entered the current crisis with leverage ratios of only 2 percent instead of well
over 5 percent. It is interesting to note that Mark Carney, the Governor of the Bank of
Canada, is convinced that Canadian banks, which are also subject to a leverage ratio, are
"healthier than their international peers" because "their leverage is markedly lower".20
Given these positive effects of a leverage ratio, what are the arguments against it? In my
view, there are three potential short-comings. They are the treatment of off-balance-sheet
exposures, pro-cyclicality, and banks' profitability. Let me briefly address these in turn.
•
Off-balance-sheet exposures: To obtain the leverage ratio, capital is divided by total
assets. Obviously, such a simple calculation fails to take into account
off-balancesheet items. The introduction of a leverage ratio could therefore encourage banks to
build up large off-balance-sheet exposures. There are two responses to this
potential problem. First, this is precisely why it is important that a leverage ratio only
be used as a supplement to Basel II. To the extent that a move to off-balance-sheet
activities raises banks' risk, Basel II will result in higher capital charges - and
thereby reduce banks' incentives and possibilities to arbitrage around a leverage
ratio. More importantly, the Basel Committee is now in the process of improving the
treatment of off-balance-sheet items under Basel II. Second, if we conclude that
despite the ongoing reforms of Basel II, off-balance-sheet exposures continue to
undermine adequate capital provisioning, the leverage ratio can easily be enhanced
to include such exposures. In Canada, for instance, some off-balance-sheet items
are added to banks' total assets when calculating the leverage ratio. Alternatively,
we could go further and consider defining a "managed leverage ratio" as proposed
by Professor Joseph Mason of Louisiana State University, "which takes all the
securitisations and puts them back on the balance sheet".21
•
Pro-cyclicality: There are valid concerns that a leverage ratio may amplify the
financial cycle. First, the imposition of a leverage ratio in the middle of the current
crisis would put additional de-leveraging pressure on banks. Second, in the long run
it would make the availability of credit more volatile. Banks would be forced to cut
down on lending in a downturn in order to comply with the leverage ratio
requirements. Unfortunately, this so-called pro-cyclicality is inherent to all forms of
capital regulation. The problem stems from the fact that in most cases, specific
capital minima have to be respected throughout the cycle. In Switzerland, in a recent
reform of the large banks' capital requirements, the Federal Banking Commission
embarked upon a pragmatic approach to address this dilemma. In normal times,
banks will be required to hold capital significantly in excess of the regulatory minima.
Conversely, when the cycle turns, they will be allowed to dip into the capital cushion.
Naturally, the Swiss authorities are acutely aware that imposing tighter capital
requirements right now would be pro-cyclical. Under the new regime, the capital
requirements have to be met by 2013. If necessary, this implementation window will
be extended further.
•
Finally, let me address the question of banks' profitability: This is a tricky question,
which requires a two-part answer.
First, capital requirements effectively reduce the value of a bank's explicit
o
or implicit government safety net. If we think of the safety net as a put
option for the owner of the bank, capital requirements effectively reduce the
price of that put option. In other words, banks have to bear a larger share of
their potential losses themselves. This, of course, is bad news for the
banks. Distortions due to the safety net are the main rationale for capital
regulation. Capital requirements aim to correct these distortions and
strengthen the motivation of banks to avoid excessive risks. While this
comes at a cost to banks, it increases overall efficiency and economic
welfare.
o Second, capital requirements reduce the tax shield of debt. Debt has an
advantage over equity capital in the sense that payments to debt holders
are deducted from profits. In contrast, payments to shareholders, i.e.,
dividends, are made out of profits and hence are subject to corporate taxes.
Forcing banks to hold more capital reduces their tax shield and thereby
diminishes banks' market value. What are the orders of magnitude we are
talking about here? Let me offer you a very rough back-of-the-envelope
calculation using publicly available data in Switzerland. Assume that a bank
has to increase its leverage ratio from 1% to 5%. If this bank is subject to
an effective tax rate of 20%, the increase in capital will reduce the bank's
total market value by less than 1%.
However, these costs notwithstanding, banks and shareholders may also benefit from
holding more capital. For instance, banks that were more conservatively capitalised before
the outset of the current crisis have now benefited from their relative strength. In the area of
wealth management, for instance, stronger banks have been successful in attracting clients
from weaker banks. Moreover, looking at the poor performance of thinly capitalised banks'
stocks over the last decade or so, low leverage ratios do not seem very attractive. Our
empirical analysis suggests that risk-adjusted stock returns of banks do not increase with
leverage. A cross-sectional comparison of risk-adjusted returns with other industries is also
sobering. The performance of the relatively low-capitalised banking sector has been
devastating during the last decade.
7. Conclusion
To conclude, leverage has been a major contributing factor in the current financial crisis.
Excessive leverage has amplified the shocks to the financial system. Moreover, the now
inevitable de-leveraging is imposing further stress on the system. To enhance the
longerterm resilience of the financial system, effective regulation to curtail banks' leverage is
required.
In an attempt to put a lower bound on banks' leverage, I strongly support enhancing current
risk-weighted capital requirements with a simple leverage ratio. A leverage ratio effectively
serves as a safety valve against the weaknesses and shortcomings of risk-weighted
requirements. It ensures a minimum capital buffer that protects banks against unexpected
losses and underestimation of risk. As we have learned from the current crisis, the failure of
risk models may quickly turn banks that seem comfortably capitalised into poorly capitalised
banks. Let me emphasise again that I don't advocate replacing the current Basel II regime
with a leverage ratio. This would be unwise, as we would forgo all the advantages of the
riskweighted requirements. In particular, we would lose valuable indicators of banks' levels of
risk. And, quite frankly, there is no real alternative in sight, at least not readily.
In discussions with my central banking and regulatory colleagues I detect increasing interest
and willingness to examine and consider the proposal of a leverage ratio as a complement to
the risk-weighted capital regime under Basel II. Governor Nout Wellink, the Chairman of the
Basel Committee on Banking Supervision, has recently said that the committee is currently
considering measures to strengthen Basel II by supplementing it "with simple, transparent
gross measures of risk".22 Last month, the German Council of Economic Experts advised the
German government and parliament to introduce a leverage ratio as a robust supplement to
Basel II.23 Other countries may also find it worthwhile to consider introducing a leverage
ratio, even if any formal international agreement should fail to materialise. In doing so they
would not only enhance financial stability in their own banking systems, but would also
contribute to a more stable international financial system. Finally, it is encouraging to note
that a number of banks have made voluntary commitments not to exceed certain predefined
leverage limits.
Adding a leverage ratio to Basel II will reinforce banks' capital and strengthen capital
regulation. However, we must remain realistic. Introducing a leverage ratio doesn't solve
everything. A leverage ratio addresses excessive leverage in the banking system. It does not
address credit concentration, excessive maturity mismatch or undue reliance on asset
market liquidity. Financial crises, let alone financial cycles will never be eliminated. Our aim
must be to ensure that the negative consequences, both to banks and to the real economy,
remain manageable. Putting in place a shock-absorbing leverage ratio to complement the
risk-weighted framework of Basel II will help us get one step closer to this goal.