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.

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.