WASHINGTON – A simmering debate about whether the leverage ratio or risk-weighted capital rules should rightly act as the binding constraint on the biggest banks is likely to soon come to a head.

"This is going to be one to the defining issues of 2017, both in terms of the Basel IV framework and in the U.S. post-election Dodd-Frank rewrite, which I think we are going to get," said Karen Shaw Petrou, managing partner of Federal Financial Analytics. "You're going to see a lot … trying to deal with its significant and adverse impacts where it is a binding constraint. And I think politically [it will be considered] because it's an easy thing to do to look tough."

At issue is the role the leverage ratio should play in capital requirements for banks – and the calculations used to establish it.

Capital requirements have evolved over time since 1981 when the first explicitly set numerical capital adequacy minimums were specified by regulators. The Basel process, beginning later that decade, set out to ensure that capital requirements were risk-based rather than just a simplistic leverage ratio.

Yet just as many consider a leverage requirement as too simple, so critics view risk-based requirements as too lax, arguing it leaves the process open to gaming by institutions. Far from fading after the financial crisis, the tug-of-war between leverage vs. risk-based requirements has only gained steam in the post-reform era.

Leading the fight against relying on risk-based models are policymakers like Federal Deposit Insurance Corp. Vice Chairman Thomas Hoenig, who wrote in an op-ed last month that the leverage ratio is "more useful" because it forgoes the inevitable haggling over determining which assets are most risky.

"A risk-based capital system makes bank regulators a partner with management in assigning risk weights, creating moral hazard by making regulators culpable when risks are misjudged," Hoenig said. "This makes it more difficult for governments to let the largest banks fail because they have had a hand in that failure."

He wasn't just concerned with the dominance of the leverage ratio, however, but also how it was calculated. Hoenig and others worry too that banks will chip away at the effectiveness of the leverage ratio by pushing for changing to its calculation.

This fear appeared to be partially realized in July when the Bank of England revised its leverage ratio in July to discount cash deposits held at the central bank from the denominator. While it insisted that would not result in a net reduction of capital requirements because it will "recalibrate" its requirements for the adjustment, many institutions in the U.S. are hoping domestic regulators will follow suit.

Esther George, who took Hoenig's previous job as president of the Federal Reserve Bank of Kansas City, said she's skeptical of such a plan or other moves to revise the leverage ratio.

"I think what these banks are trying to do is, they have a lot of assets [and] the leverage ratio lowers their returns," George said. "And that I think is where the conflict is – they don't want lower returns."

Congressional leaders are also rethinking the role of the leverage ratio. In June, House Financial Services Committee Chairman Jeb Hensarling, R-Texas, laid out a long-awaited Dodd-Frank reform bill that would allow banks with at least a 10% leverage ratio and a Camels rating of 1 or 2 to bypass many of the Dodd-Frank and Basel III compliance requirements. Hensarling said the leverage ratio was his preferred vehicle for establishing adequate capital because "risk-weighting is simply not as effective."

But many regulators appear to disagree. Federal Reserve Gov. Daniel Tarullo, who heads the board's supervisory committee, suggested in a speech in July than the agency should be looking of ways to simplify the capital regimes, specifically for the smallest banks, but expressed skepticism of Hensarling's plan.

"A leverage ratio is very important … but the risk-weighting actually focuses on the actual riskiness of the portfolio, so my view is you really need both," Tarullo said.

Wayne Abernathy, executive vice president of financial institutions policy and regulatory affairs at the American Bankers Association, said the role of the leverage ratio is a "very important issue" for banks. He takes comfort in Tarullo's willingness to stand behind the principle that capital constraints for banks should be risk-based, and hoped that regulators will continue to evaluate the mix of capital requirements – both risk-based and leverage-based – to determine where the sweet spot is.

"What we hope happens, and what I think we're seeing early indications of, is a continual evaluation of the overall mix of capital ratios – and how we measure capital, how you supervise for capital," Abernathy said. "It is not … generally perceived as an either/or. You combine the two to come up with the right way to measure capital most effectively from a supervisory point of view."

Greg Baer, president of the Clearing House Association, said there's a way to potentially have the best of both worlds. One reasonable place to draw a bright line would be to exempt High-Quality Liquid Assets – as defined by regulators for the purposes of the Liquidity Coverage Ratio – from the leverage ratio. That would avoid the "slippery slope" concern of having various and ever-growing classes of assets become exempt from the leverage ratio by allowing regulators to remain in control of determining which assets are considered liquid enough to both stave off a run, and would increase consistency between the LCR and the leverage ratio.

"It does seem like HQLA is a fairly easy line to draw," Baer said. "HQLA is basically a set of assets, in some cases subject to haircuts, that the regulators have already determined pursuant to regulation are extraordinarily safe assets that can protect a bank against a run. They ought to be able to say those are safe enough that you don't have to hold additional capital."

But Wall Street critics remain skeptical of any bank-sanctioned re-envisioning of the leverage ratio, precisely because it undermines the sole strength of the leverage ratio – its blindness to type or class of asset. Dennis Kelleher, president of public advocacy group Better Markets, said the simplicity and directness with which it is applied ensures that large banks hold a minimum quantity of equity capital that is not subject to gamesmanship, exemptions or reconsideration.

"Every time you make an exception to the bright line, you introduce judgment and uncertainty, and inevitably it leads to another clarification, elaboration, exception, until you end up with a Swiss-cheese capital regime that utterly fails, as happened in 2008," Kelleher said. "The whole point of the leverage ratio is that it is a bright line that removes judgment and creates without question an equity capital cushion to protect taxpayers."

Kelleher added that the purpose of having banks retain capital is not punitive or undermining lending. He said research suggests that banks that are capitalized in the order to 10-15% are in fact far more likely to lend. Moreover, those banks lend not only when economic conditions are good, but when they are in a downturn as well. That is because they simply have the resources to lend, rather than skating by on a thin margin.

"This is not a trade-off between sensible regulation and jobs and growth and lending," Kelleher said. "This is a debate about adequacy of the equity cushion that not only protects banks and taxpayers, but facilitates lending and actually enables greater lending."

One thing that is certain is that Hensarling's bill has a long way to go if it is to bridge the gap between the proponents of risk-weighting and its skeptics. Baer said the legislation as written would essentially be useful only for smaller banks, since certain businesses require the maintenance of large volumes of low-risk assets that render a 10% equity capital requirement unworkable.

"Under that criterion, no bank that's active in the capital markets or is doing any kind of debt trading is ever going to qualify for that off-ramp, because those activities require you to hold really low-risk assets like Treasuries," Baer said. "And I think it's turned out that many other banks can't qualify because they have lots of reserves at the Fed and other low-risk assets, and who wants to hold 10% capital against that?"

Kelleher was opposed to the bill for the opposite reason, arguing that the leverage capital requirement was too low. Estimating based on capital shortfalls suffered in the 2008 financial crisis, he said something more on the order of 20% might be required to forgo the various safeguards put in place by the Basel accords and Dodd-Frank.

"Before you start eliminating other protections in exchange for capital, the level of capital would have to be quite high, or you're creating a house of cards," Kelleher said. "The fact that the hole in 2008 was higher than 20% should make people pretty humble when talking about equity capital at 10%."

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