University of Southern California

A Flawed Solution: The Difficulties of Mandating a Leverage Ratio in the United States

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Note by John Holman
From Volume 84, Number 3 (March, 2011)

While the causes of the recent financial crisis have been debated extensively, the conclusion that excessive leverage by financial institutions contributed to the crisis has garnered widespread support. Concerns over the role of leverage have spurred a renewed focus on banks’ ability to exploit the presence of moral hazard due to limited liability and the government’s tendency to rescue banks in distress. The crisis painfully underscored how banks use leverage to increase their expected returns while simultaneously shifting risk to creditors and the public at large.

To help address the negative externalities that result from the leveraging process, the United States has traditionally set capital requirements for its banks by using a non-risk-based leverage ratio in addition to risk-based capital ratios. The United States is one of only a few countries to supplement the risk-based ratios with a binding leverage ratio. Indeed, in 2004, the Basel Committee on Banking Supervision (the “Committee”) created a new international capital-requirement framework that included only risk-based ratios, reflecting a general consensus prior to the crisis that a leverage ratio was not needed to control bank risk. Bank regulators in the United States, for their part, stressed the importance of the leverage ratio as a “safety-net” and insisted that it be retained.

After the onset of the recent financial crisis, the Basel Committee experienced extreme pressure to revise its capital requirements in order to strengthen the global banking system’s ability to withstand financial shocks. The Committee responded by releasing a series of concrete proposals in December 2009 and a set of new requirements in December 2010. The new requirements include the introduction of a binding global leverage ratio (“Basel ratio”), which will differ from the U.S. leverage ratio in certain respects. Given the Committee’s prior stance that a leverage ratio was unnecessary, the Committee’s actions represent a major reversal of course. The Committee appears to have accepted the argument that the leverage ratio can serve as an effective backstop to the risk-based ratios. Despite the Committee’s about-face, banks continue to oppose a binding leverage ratio on the ground that the ratio’s insensitivity to risk can encourage banks to incur more risk, thereby undermining the ratio’s objectives.

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