Raising Leverage Ratio Weakens Bank Liquidity

The leverage ratio has traditionally been viewed as a simple, non-risk-based calculation, but nothing is simple in the context of regulatory reform. Advocates for a higher leverage ratio would add complexity – not simplicity – by diverging from generally accepted accounting principles to incorporate off-balance-sheet exposures into the calculation.

Whether explicitly acknowledged or not, supporters of a higher leverage ratio are making their own risk-based determinations to decide which off-balance-sheet exposures count and which don't. So far, they have chosen to add assets into the measure's calculation, but they're forgetting that risk-based determinations go both ways. As the debate continues, considering what on-balance-sheet assets should be excluded from a new leverage ratio is equally critical for regulators.

One of the many problems with a high leverage ratio stems from the flight to safety during periods of stress, which causes bank deposits to soar. Since 2008, while the U.S. economy has struggled, deposits have risen by $2.6 trillion, often with pronounced temporary spikes that remain on a bank's balance sheet for just a few weeks. A recent example of this occurred during the politically charged debt-ceiling crisis. At that time, deposits jumped by $73 billion, according to Federal Deposit Insurance Corp. data.

Deposits provide crucial funding for all banks, but as deposits surge, bank leverage ratios drop. Worse, sudden changes in deposit flow make banks' leverage ratios volatile. Most banks simply manage this volatility by staying well above the current leverage ratio requirements. That is, they are generally over-capitalized.

However, recent proposals advocating for increases in the leverage ratio would make it a binding capital constraint. If regulators raise the leverage ratio bar, its volatility will become a core concern for banks: They will either have to hold leverage capital significantly higher than the requirement, or be ready and willing to shed assets when ratio demands rise. What they won't be able to do is continuously go in and out of the capital markets to manage their capital levels.

Without a way of managing deposit surges, banks may find themselves suddenly undercapitalized and in violation of regulation. Under these circumstances, a higher leverage ratio could turn a political crisis, such as the debt-ceiling brinkmanship, into a banking crisis, as banks are forced to shed assets in the teeth of a declining economy.

If policymakers decide to put greater emphasis on the leverage ratio, they must also explore ways in which banks can mitigate the measure's inherent volatility without damaging their reputations by turning away depositors and discouraging potential lending relationships. One option would be to carve out safe assets, such as excess reserves held at the Federal Reserve, from the calculation, since deposits with the Federal Reserve do not change a bank's risk profile.

Carving safe assets out of the leverage ratio would also ensure that a higher ratio does not undermine a bank's liquidity strength. Another problem with putting greater emphasis on a leverage ratio is that it would encourage banks to shed liquid assets (which are the easiest to put into the markets) to improve leverage, which would be in direct conflict with good liquidity management.

The liquidity standards require banks to hold a stock of high-quality liquid assets relative to estimated cash outflows during a stress period. Any incentive to reduce highly liquid assets by including them in a leverage ratio would severely undercut the ability of banks to manage liquidity when under stress. Carving out safe assets from the leverage ratio would mitigate these conflicting incentives.

Banks embrace the importance of having an appropriate amount of capital commensurate with risk and to protect creditors against losses. Bankers uniformly believe that fully adequate levels of capital, including high-quality capital, are appropriate given the financial crisis. But capital is not a substitute for robust risk management, and the type of leverage ratio currently being considered could endanger banks' reputations, undermine prudent risk management and weaken liquidity.

As the debate continues, it is critical that leverage be viewed within the context of a broader risk management framework, and be considered a backstop to risk-based capital measures, not as a primary capital constraint.

Hugh Carney is senior counsel for the American Bankers Association.