Hoenig Rejects Claims of Leverage Ratio Critics

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WASHINGTON — Federal Deposit Insurance Corp. Vice Chairman Thomas Hoenig continued his drumbeat in support of stronger capital measures Tuesday and rejected industry claims that a rigorous leverage ratio breeds unintended consequences.

Both Hoenig and Jeremiah Norton, another FDIC board member, have recently intensified calls for a tougher leverage ratio than what would be required in the Basel III proposal.

Under the Basel accord, the largest financial institutions would face an additional 3% minimum leverage ratio on top of the minimum 4% leverage ratio for all banks.

In a speech to the International Association of Deposit Insurers in Basel, Switzerland, Hoenig said that is not enough. He reiterated his view that a tangible leverage ratio, which measures a bank's capital to assets without risk-weighting and intangibles like goodwill, is generally a better measure of a bank's capital buffer than the risk weight-laden Tier 1 ratio that is central to the Basel proposal.

"The Basel III proposal belatedly introduces the concept of a leverage ratio but calls for it to be only 3%, an amount already shown to be insufficient to absorb sizable financial losses in a crisis," Hoenig said in prepared remarks to the IADI conference. "It is wrong to suggest to the public that, with so little capital, these largest firms could survive without public support should they encounter any significant economic reversals."

He also challenged certain industry arguments about the consequences of using a tangible leverage ratio, such as claims that it would make banks less competitive, prompt bankers to load more risk onto their balance sheets and constrain credit.

He said stronger and more tangible capital would likely make banks more competitive, not less. "A level of capital that lowers risk may very well attract investors drawn to the more reliable returns," Hoenig said.

In response to the notion that equal risk weights across the asset spectrum would remove incentives for investing in safer assets, Hoenig called the claim "possible" but "unconvincing."

"With more capital at risk and without regulatory weighting schemes affecting choice, managers will allocate capital in line with market risk and returns," Hoenig said.

Hoenig argued a Tier 1 capital ratio — the principal measure in Basel III — allows institutions to game the system simply by stocking up on the assets with risk weights that result in a higher capital ratio.

"This creates the illusion that banking organizations have adequate capital to absorb unexpected losses," he said. "This 'leveraging up' has served world economies poorly."

Although he said international capital requirements should include "some form" of risk weights, Hoenig noted that banks and regulators are limited in their ability to predict what types of assets should demand higher capital.

"Despite all of the advancements made over the years in risk measurement and modeling, it is impossible to predict the future or to reliably anticipate how and to what degree risks will change," he said. "Capital standards should serve to cushion against the unexpected, not to divine eventualities. All of the Basel capital accords, including the proposed Basel III, look backward and then attempt to assign risk weights into the future. It doesn't work."

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