The misguided appeal of risk-based capital

The supplementary leverage ratio is a convenient target for critics.

The proponents of risk-based capital allege that the leverage ratio is too crude. They oppose its eliminating risk-adjusted risk weights, and say it should be modified to avoid a list of horrible consequences, including financial instability and undermining American competitiveness.

Of course, a perfect risk-based measure is preferable to an admittedly imperfect leverage ratio. But this is an example of the “nirvana fallacy.” The problem is there is no perfect risk-based measure. The real comparison is between a failed risk-based capital system and a less than perfect but still useful leverage ratio.

In reality, risk weights have more to do with lobbying and politics than economics. They are backward-looking static measures based on problematic fantasy finance models. They ignore rare, extreme economic events — also known as “black swans” — while seeking to quantify the unquantifiable nature of uncertainty. Furthermore, explaining the past is not the same as predicting the future.

Unfortunately, the risk weights at the heart of risk-based capital regimes are rarely increased to reflect changing conditions until it is too late. Just look at the supposedly safe structured finance products that collapsed during the financial crisis. Are we so sure that risk-based capital measures will perform better the next time around?

Chris Ratcliffe/Bloomberg

Finally, risk-based capital is susceptible to gaming by taking risks not recognized by models. “Systemically important financial institutions” will crowd into the highest-risk assets within each supposedly safe risk class to achieve higher nominal non-risk adjusted returns. They will also engage in unproductive regulatory arbitrage to develop products exploiting the rules. This is great for expensive advisers and staff, but of doubtful real economic value. The results are a predictable increase in supposedly safe but mispriced trading assets, as in the London Whale incident.

The real purpose of risk-based capital methodology is to increase leverage by moving assets off the regulatory balance sheet. The problem is out of sight and out of mind, until a crisis hits.

On average, risk-based assets represent about 55% of total assets on a bank’s balance sheet. Some inventive banks have achieved the remarkable feat of having over 80% of their assets deemed riskless and off the balance sheet. Interestingly, low-leverage-ratio European institutions continue to suffer valuation discounts compared to their American competitors with a higher required leverage ratio. So much for the leverage ratio being un-American.

The leverage ratio standard should be viewed as a floor. You should prepare for hazards you cannot predict. How prepared you should be depends on your risk appetite as reflected in your capital level. Remember: domestic bank asset losses exceeded 7% during the last crisis. God help us in the next crisis if a 5-to-6% leverage ratio is viewed by SIFIs as a ceiling. Nonetheless, if SIFIs want to increase leverage, then we can directly effect that outcome by reducing the leverage ratio requirement. If you want faster highway travel then change the speed limit — not the speedometer.

Risk-based capital was implemented under Basel II. It was worse than ineffectual as it provided a false sense of security. Institutions with supposedly adequate risk-based capital like Northern Rock and others collapsed. Consequently, regulators reinstated a modest post-crisis leveraged ratio requirement. The leverage ratio, unlike risk-based capital, works in practice while not in theory.

I would rather be roughly right with a leverage ratio than precisely wrong with pseudo-scientific risk-based capital. Let us hope regulators considering risk-based capital measures and leverage ratio modifications keep this in mind.