WASHINGTON — Jeremiah Norton, a board member of the Federal Deposit Insurance Corp., said Wednesday that regulators should consider proposing a stronger leverage ratio for banks to help protect the financial system.
In a speech to the Florida Bankers Association, Norton said regulators should require banks to meet a minimum ratio of tangible common equity to non-risk-weighted assets, warning that the current Basel III proposal relies excessively on risk-weightings that do not adequately capture risk.
"Regulators should evaluate the shortcomings of a risk-weighted assets regime and consider a more balanced approach to capital regulation," said Norton.
He said the leverage ratio should wind up being stricter than the current Basel III plan that U.S. regulators are working to implement. Norton's unease with the current approach rests on its reliance on risk-weighted assets, like residential mortgages and sovereign debt, that fail to account properly for risk.
"A more robust leverage ratio would calculate these positions on a gross basis to capture the magnitude of these risks, which may not be reflected properly when accounted for on a net basis," said Norton.
For one, he says, research has shown a leverage ratio based on total assets is a "better predictor" of bank distress than a risk-based capital ratio. Secondly, the methodology used to calculate risk-weighted assets is often too complex and provides banks with an opportunity to manage those assets in order to reduce their capital requirements. Finally, investors have "lost confidence" in how risk-weighted assets are calculated, he said.
"I am concerned that the marketplace is becoming too reliant on the signaling from the results of regulatory stress tests as opposed to proper investor due diligence," said Norton. "If fewer investors are able to understand and analyze banks' capital protection relative to balance sheet risks, markets will become less efficient and market discipline will erode."
Under the proposed Basel III framework, regulators require a minimum leverage ratio of 4%, but the ratio for a well-capitalized institution is 5%. The largest financial institutions are subject to a supplemental leverage ratio of 3%. Norton, a former banker at JPMorgan, said regulators should go beyond those requirements.
He urged U.S. regulators to take the lead in "supporting a strong leverage ratio" in order to help promote economic growth and said doing so would be consistent with the existing Basel III framework.
"A modernized leverage ratio requirement would work alongside the Basel risk-based capital approach," said Norton.
Norton acknowledged that other countries may not follow the U.S.' lead on a tougher leverage ratio.
"The effects of imposing a leverage ratio on the global competitiveness of U.S. banks should be reviewed and considered carefully," said Norton. "The regulatory agencies should propose a leverage rule and allow commenters to present all sides of the issues so that the regulatory community can make thoughtful and reasoned decisions."
Despite his reservations, he said risk-weighted capital measurements could still provide regulators with useful insights into a bank's asset structure and lending investment trends.
"Absent risk-weights, it could be argued that banks would be incentivized to carry a greater portion of high-risk assets on their balance sheets to earn higher yields for the same cost of capital as low-risk, lower yielding assets," said Norton.