Leverage Ratios: An Overly Simplistic Capital Measure

The risk-based capital system regulators have built over the last two decades may not be perfect, but it remains a better way of gauging and guarding against the true risks associated with a bank than the one-dimensional leverage ratio to which some policymakers want to return.

The concept behind risk-based capital is simple and fair: Make capital commensurate with underlying risk. It's true that putting this into practice has not been simple. Risk weights, for instance, can't fully account for changes in competition, new products and broad economic downturns.  And the 2008 financial crisis demonstrated that there are more unknown risks that risk weights cannot capture.

But to abandon the risk-based approach and rely instead on pre-1930s Depression-era ratios as some in Congress have suggested is to ignore the tremendous progress that has been made to make the financial system safer for depositors. It also takes us further from customized bank supervision, an approach that regulators have recently recognized is important to preserving the banking industry's diversity.

So, why the love affair with the leverage ratio? We examined the average leverage and Tier 1 risk-based ratios for banks in operation for the last ten years (successful banks) and compared them to the average ratios of the group of banks that failed in 2008, 2009 and 2010. As you can see, the leverage ratio did little to distinguish banks that have failed since 2008 with those that remained healthy. Two similarly-sized institutions can have dramatically different risk profiles, so the leverage ratio provides little useful information on the safety and soundness of a bank. This is why the risk-based ratio, for all its shortcomings, did a much better job distinguishing banks that would go on to fail from those that survived. 

As a group, the failed banks were more aggressive lenders with significantly higher loan-to-deposit ratios going into the crisis than surviving banks.  Once economic conditions deteriorated, losses overwhelmed capital and led to failures.  Bottom line: The majority of these institutions failed because the losses were so great that no reasonable level of capital would have been enough to absorb them.  More than half of the institutions that failed between 2008 and 2010 would still have failed if they had had a tangible equity capital ratio of 25% in 2008.

Everyone shares the goal of having an appropriate amount of capital to protect creditors against losses.  Everyone shares the general belief that more capital, including high-quality capital, is appropriate given the experiences of the financial crisis – and that's why market and regulatory pressures have already led to a significant increase in both the level of capital and its quality. 

But "more capital" shouldn't be confused with "you can't have too much capital" – because you can. Capital comes at a cost – both to banks and the economy at large – in the form of forgone lending as institutions shrink to meet extreme capital-to-asset ratios. 

Risk-based capital is far from perfect, but the debate should be on how it can be meaningfully improved instead of calling for a return to the age of black-and-white TVs and no Internet.  We all want more simplicity, but our world is no longer simple. It's time to find the right capital rules for the risks taken, regardless of an institution's size. 

James Chessen is chief economist for the American Bankers Association.