In defence of the leverage ratio
Regular readers know that I blame risk-based capital requirements for many of the ills of our current banking system. Before the introduction of Basel regulations, banks’ capital level used to be assessed using more standard and simple leverage ratios (equity or capital/total assets). Those ratios have mostly disappeared since the end of the 1980s but Basel 3 is now re-introducing its own version (Tier 1 capital/total exposures).
While I believe there should not be any regulatory minimum capital requirement, I also do believe that, if regulators had to pick one main measure of capitalisation, it should be a standard leverage ratio. All RWA-based ratios should be scrapped.
A new study just added to the growing body of evidence that leverage ratios perform better than RWA-based ones as predictor of banks’ riskiness. Andrew Haldane, from the BoE, has been a long-time supporter of leverage ratios. Admati and Hellwig also backed non-risk weighted ratios. Another paper recently suggested that there was nothing in the literature that justified the level of risk-weights.
Still, most economists, central bankers and regulators consider leverage ratios as mere backstops to complement the more ‘scientific’ (read, more complex, as there is no science behind risk-weights) Basel RWA-based ratios. See this speech from Andreas Dombret, which sums up most criticisms towards simple leverage ratios:
Yet a leverage ratio would also create the wrong incentives. If banks had to hold the same percentage of capital against all assets, any institution wanting to maximise its profits would probably invest in high-risk assets, as they produce particularly high returns. This would eradicate the corrective influence of capital cover in reducing risk.
Unfortunately, Mr. Dombret and many others are very misinformed.
A leverage ratio would not incentivise banks to leverage up to the allowed limit. Under Basel’s RWA framework, no banks operated with the bare regulatory minimum. Critics forget that different banks have different risk aversion and different risk/reward profiles. Some banks generate relatively low RoEs in return for lower level of risk. Others are willing to take on more risks to generate higher margins and higher RoEs. Banks are not uniform.
Banks would not necessarily pile into the riskiest assets under a leverage ratio either. The answer to this is the same as above. Banks have different cultures and different risk/return profiles to offer to investors. There is no reason why all banks would suddenly lend to the riskiest borrowers to improve their earnings. Such criticism could also easily apply to Basel capital ratios: why didn’t all banks follow the same investment strategy? Critics forget that banks do not try to maximise their profits. They try to maximise their risk-adjusted profits. Finally, such argument only demonstrates its proponents’ ignorance of banking history, as if all banks had always been investing in the riskiest assets in the 300 years before Basel introduced those risk-weights.
RWA-based capital ratios are very patronising: because the riskiness of the assets is already embedded within the ratio, banks are effectively telling markets how risky they are. This became overly sarcastic with Basel 2, which allowed large banks to calculate their own risk-weights (i.e. the so-called ‘internal rating based’ method). It has been proved that, for a given portfolio of assets, risk-weights were considerably varying across banks (see here and here). Given the same balance sheet, one bank could, say, report a 10% Tier 1 ratio, and another one, 14%, implying massive variations in RWA density (RWAs/total assets). A given bank could also change its RWA calculation model (and hence its RWA density) in between two reporting periods, making a mockery of period to period comparison. Of course, all this is approved by regulators. Consequently RWA-based capital ratios became essentially meaningless.
As a result, a leverage ratio would provide a ‘purer’ measure of capitalisation that markets could then compare with their own assessment of banks’ balance sheet riskiness.
Scrapping RWA-based capital ratios would also provide major economic benefits. As regularly argued on this blog, RWA-incentivised regulatory arbitrage has been hugely damaging for the economy and is in large part responsible for the recent internationally-coordinated housing bubbles and ‘secular’ low level of business lending. Getting rid of such regulatory ratio would benefit us all by removing an indicator that has big distortionary effects on the economy.
Of course, there are still a few issues, though they remain relatively minor. The main one is that differences in accounting standards across jurisdictions do not lead to the same leverage ratios (i.e. US GAAP banks have much less restrictions to net their derivative positions than IFRS ones). But those accounting issues can easily be corrected if necessary for international comparison. The second one is what definition of capital to use: common equity? Tier 1 capital? Another problem is the fact that very low risk banks, which don’t need much capital, would also get penalised. In the end, it’s likely that any regulatory ratio will prove distortive in a way or another. Why not scrap them all and let the market do its job?
Hummel vs. Haldane: the central bank as central planner
Recent speeches and articles from most central bankers are increasingly leaving a bad aftertaste. Take this latest article by Andrew Haldane, Executive Director at the BoE, published in Central Banking. Haldane describes (not entirely accurately…) the history and evolution of central banking since the 19th century and discusses two possible paths for the next 25 years.
His first scenario is that central banks and regulation will step backward and get back to their former, ‘business as usual’, stance, focusing on targeting inflation and leaving most of the capital allocation work to financial markets. He views this scenario as unlikely. He believes that the central banks will more tightly regulate and intervene in all types of asset markets (my emphasis):
In this world, it would be very difficult for monetary, regulatory and operational policy to beat an orderly retreat. It is likely that regulatory policy would need to be in a constant state of alert for risks emerging in the financial shadows, which could trip up regulators and the financial system. In other words, regulatory fine-tuning could become the rule, not the exception.
In this world, macro-prudential policy to lean against the financial cycle could become more, not less, important over time. With more risk residing on non-bank balance sheets that are marked-to-market, it is possible that cycles in financial assets would be amplified, not dampened, relative to the old world. Their transmission to the wider economy may also be more potent and frequent. The demands on macro-prudential policy, to stabilise these financial fluctuations and hence the macro-economy, could thereby grow.
In this world, central banks’ operational policies would be likely to remain expansive. Non-bank counterparties would grow in importance, not shrink. So too, potentially, would more exotic forms of collateral taken in central banks’ operations. Market-making, in a wider class of financial instruments, could become a more standard part of the central bank toolkit, to mitigate the effects of temporary market illiquidity droughts in the non-bank sector.
In this world, central banks’ words and actions would be unlikely to diminish in importance. Their role in shaping the fortunes of financial markets and financial firms more likely would rise. Central banks’ every word would remain forensically scrutinised. And there would be an accompanying demand for ever-greater amounts of central bank transparency. Central banks would rarely be far from the front pages.
He acknowledged that central banks’ actions have already considerably influenced (distorted?…) financial markets over the past few years, though he views it as a relatively good thing (my emphasis):
With monetary, regulatory and operational policies all working in overdrive, central banks have had plenty of explaining to do. During the crisis, their actions have shaped the behaviour of pretty much every financial market and institution on the planet. So central banks’ words resonate as never previously. Rarely a day passes without a forensic media and market dissection of some central bank comment. […]
Where does this leave central banks today? We are not in Kansas any more. On monetary policy, we have gone from setting short safe rates to shaping rates of return on longer-term and wider classes of assets. On regulation, central banks have gone from spectator to player, with some granted micro-prudential as well as macro-prudential regulatory responsibilities. On operational matters, central banks have gone from market-watcher to market-shaper and market-maker across a broad class of assets and counterparties. On transparency, we have gone from blushing introvert to blooming extrovert. In short, central banks are essentially unrecognisable from a quarter of a century ago.
This makes me feel slightly unconfortable and instantly remind me of the – now classic – 2010 article by Jeff Hummel: Ben Bernanke vs. Milton Friedman: The Federal Reserve’s Emergence as the U.S. Economy’s Central Planner. While I believe there are a few inaccuracies and omissions in Hummel’s description of the financial crisis, his article is really good and his conclusion even more valid today than at the time of his writing:
In the final analysis, central banking has become the new central planning. Under the old central planning—which performed so poorly in the Soviet Union, Communist China, and other command economies—the government attempted to manage production and the supply of goods and services. Under the new central planning, the Fed attempts to manage the financial system as well as the supply and allocation of credit. Contrast present-day attitudes with the Keynesian dark ages of the 1950s and 1960s, when almost no one paid much attention to the Fed, whose activities were fairly limited by today’s standard. […]
As the prolonged and incomplete recovery from the recent recession suggests, however, the Fed’s new central planning, like the old central planning, will ultimately prove an unfortunate and possibly disastrous failure.
The contrast between central bankers’ (including Haldane’s) beliefs of a tightly controlled financial sector to those of Hummel couldn’t be starker.
Where it indeed becomes really worrying is that Hummel was only referring to Bernanke’s decision to allocate credit and liquidity facilities to some particular institutions, as well as to the multiplicity of interest rates and tools implemented within the usual central banking framework. At the time of his writing, macro-prudential policies were not as discussed as they are now. Nevertheless, they considerably amplify the central banks’ central planner role: thanks to them, central bankers can decide to reduce or increase the allocation of loanable funds to one particular sector of the economy to correct what they view as financial imbalances.
Moreover, central banks are also increasingly taking over the role of banking regulator. In the UK, for instance, the two new regulatory agencies (FCA and PRA) are now departments of the Bank of England. Consequently, central banks are in charge of monetary policy (through an increasing number of tools), macro-prudential regulation, micro-prudential regulation, and financial conduct and competition. Absolutely all aspects of banking will be defined and shaped at the central bank level. Central banks can decide to ‘increase’ competition in the banking sector as well as favour or bail-out targeted firms. And it doesn’t stop here. Tighter regulatory oversight is also now being considered for insurance firms, investment managers, various shadow banking entities and… crowdfunding and peer-to-peer lending.
Hummel was right: there are strong similarities between today’s financial sector planning and post-WW2 economic planning. It remains to be seen how everything will unravel. Given that history seems to point to exogenous origins of financial imbalances (whereas central bankers, on the other hand, believe in endogenous explanations, motivating their policies), this might not end well… Perhaps this is the only solution though: once the whole financial system is under the tight grip of some supposedly-effective central planner, the blame for the next financial crisis cannot fall on laissez-faire…
The obsession of stability
One of the outcomes of the financial crisis has been that regulators are now obsessed with instability. Or stability. Or both.
They have been on a crusade to eliminate the evil risks to ‘financial stability’, and nothing seems to be able to stop them (ok, not entirely true). Banks, shadow banking, peer-to-peer lending, crowdfunding, private equity, payday lenders, credit cards…
Their latest target is asset managers. In a new speech at London Business School, Andrew Haldane, a usually ‘wise’ regulator, seems to have now succumbed to the belief that regulators know better and have the powers to control and regulate the whole financial industry (see also here). This is worrying.
Haldane now views every large asset manager as dangerous and many investment strategies as potentially amplifying upward or downward spiral in asset prices, representing ‘flaws’ in financial markets that regulators ought to fix. I believe this is strongly misguided.
In their quest to cure markets from any instability, regulators are annihilating the market process itself. I would argue that some level of instability is not only necessary, but is also desirable.
First, instability reflects human action; the allocation of resources by investors and entrepreneurs. Some succeed, some fail, prices go up, prices go down, everybody adapts. Sometimes many, too many, investors believe that a new trend is emerging, indeed amplifying a market movement and subsequently leading to a crash. But crashes and failures are part of the learning process that is inherent to any capitalist and market-based society. Suppress or postpone this process and don’t be surprised when very large crashes occur. On the other hand, an unhampered market would naturally limit the size of bubbles and their subsequent crashes as market actors continuously learn from their mistakes.
Second, instability enhances risk management. Instability is necessary because it induces fear in markets participants’ behaviour, who then take risks more seriously. By suppressing instability, regulators would suppress risk assessment and encourage risky behaviours: “there is nothing to fear; regulators are making sure markets are stable.” The illusion of safety is one of the most potent risks there is.
Nevertheless, regulators, on their quest for the Holy Grail of stability, want to regulate again and again. On the back of flawed instability or paternalistic consumer protection arguments, and despite seemingly showing poor understanding of financial industries, they are trying to implement regulations that would at best limit, at worst dictate, market actors’ capital allocation decisions. Adam Smith would turn in his grave (along with his invisible hand, who is now buried next to him).
In the end, regulators’ obsession for stability and protection creates even stronger systemic risks. In fact, the only ‘stable’ society is what Mises called the evenly-rotating economy, the one that never experiments. Nothing really attractive.
Funny enough, in his speech, Haldane even acknowledged regulation as one of the reasons underlying some of the current instability:
Risk-based regulatory rules can contribute further to these pro-cyclical tendencies. […]
There have been several incidences over recent years of regulators loosening regulatory constraints to forestall concerns about pro-cyclical behaviour in a downswing. […]
In particular, regulation and accounting appear to have played a significant role.
I guess he didn’t get the irony.
A central banker contradiction?
Last week, Mark Carney, the governor of the Bank of England, was at Cass Business School in London for the annual ‘Mais Lecture’. Coincidentally, I am an alumnus of this school. And I forgot to attend… Yes, I regret it.
Carney’s speech was focused on past, current, and future roles of the BoE. In particular, Carney mentioned the now famous monetary and macroprudential policies combination. It’s a classic for central bankers nowadays. They all have to talk about that.
In January, Andrew Haldane, a very wise guy and one my ‘favourite’ regulators, also from the BoE, made a whole speech about the topic. As Jens Weidmann, president of the Bundesbank, did in February.
I am not going to come back to the all the various possible problems caused and faced by macroprudential policies (see here and here). However, there seems to be a recurrent contradiction in their reasoning.
This is Carney:
The transmission channels of monetary and prudential policy overlap, particularly in their impact on banks’ balance sheets and credit supply and demand – and hence the wider economy. Monetary policy affects the resilience of the financial system, and macroprudential policy tools that affect leverage influence credit growth and the wider economy. […]
The use of macroprudential tools can decrease the need for monetary policy to be diverted from managing the business cycle towards managing the credit cycle. […]
That co-ordination, the shared monitoring of risks, and clarity over the FPC’s tools allows monetary policy to keep Bank Rate as low as necessary for as long as appropriate in order to support the recovery and maintain price stability. For example expectations of the future path of interest rates – and hence longer-term borrowing costs – have not risen as the housing market has begun to recover quickly.
First, it is very unclear from Carney’s speech what the respective roles of monetary policy and macroprudential policies are. He starts by saying (above) that “monetary policy affects the resilience of the financial system”, then later declares “macroprudential policy seeks to reduce systemic risks”, which is effectively the same thing. At least, he is right: both policy frameworks overlap. And this is the problem.
This is Haldane:
In the UK, the Bank of England’s Monetary Policy Committee (MPC) has been pursuing a policy of extra-ordinary monetary accommodation. Recently, there have been signs of renewed risk-taking in some asset markets, including the housing market. The MPC’s macro-prudential sister committee, the Financial Policy Committee (FPC), has been tasked with countering these risks. Through this dual committee structure, the joint needs of the economy and financial system are hopefully being satisfied.
Some have suggested that having monetary and macro-prudential policy act in opposite directions – one loose, the other tight – somehow puts the two in conflict [De Paoli and Paustian, 2013]. That is odd. The right mix of monetary and macro-prudential measures depends on the state of the economy and the financial system. In the current environment in many advanced economies – sluggish growth but advancing risk-taking – it seems like precisely the right mix. And, of course, it is a mix that is only possible if policy is ambidextrous.
Contrary to Haldane, this does absolutely not look odd to me…
Let’s imagine that the central bank wishes to maintain interest rates at a low level in order to boost economic activity after a crisis. After a little while, some asset markets start looking ‘frothy’ or, as Haldane says, there are “renewed signs of risk-taking.” Discretionary macroprudential policy (such as increased capital requirements) is therefore utilised to counteract the lending growth that drives those asset markets. But there is an inherent contradiction here: one of the goals that low interest rates try to achieve is to boost lending growth to stimulate the economy…whereas macroprudential policy aims at…reducing it. Another contradiction: while low interest rates tries to prevent deflation from occurring by promoting lending and thus money supply growth, macroprudential policy attempts to reduce lending, with evident adverse effects on money supply and inflation…
Central bankers remain very evasive about how to reconcile such goals without entirely micromanaging the banking system.
I guess that the growing power of central bankers and regulators means that, at some point, each bank will have an in-house central bank representative that tells the bank who to lend to. For social benefits of course. All very reminiscent of some regions of the world during the 20th century…
Weidman is slightly more realistic:
We have to acknowledge that in the world we live in, macroprudential policy can never be perfectly effective – for instance because safeguarding financial stability is complicated by having to achieve multiple targets all at the same time.
Andy Haldane has a few lessons to teach Adair Turner
Andy Haldane, the Executive Director of Financial Stability at the Bank of England, is possibly one of the most knowledgeable top regulators around. Not only knowledgeable actually. Also modest. What I like in him is that he knows what he doesn’t know. He is the representative of common sense among regulators; it’s almost a pleasure to listen to him. To me, the contrast is sharp between Haldane and Lord Adair Turner, who should probably learn a thing or two from him.
In another (long) remarkable speech given at the Kansas City Fed on 31 August (sorry, I’m only catching up with that now) called ‘The dog and the frisbee‘, he demonstrates again his immense knowledge and modesty. He argues that, often, simple and straightforward rules are much more effective than complex and adaptive rules. Of course, what he targets here is the increasingly large Basel regulatory framework and the risk-weighted assets-based regulatory capital ratios. He many times cites research highlighting how unweighted measures performed better in spotting institutions at risk of collapse.
He based his opinion on his economic beliefs. He and I both disagree with the rational expectations hypothesis, which underlines most modern mainstream economic and finance theory. Financial theory is dominated by the ‘modern portfolio theory’, from which is derived some of the most basic financial tools (Capital Asset Pricing Model for example). I’ll get back to this in another post but the assumptions underlying CAPM/cost of capital and modern portfolio theory in general are highly unrealistic. Yet, few practitioners seem to care. Mathematics has taken over as the only way to describe the world and invest. It looks scientific. So it looks good and must be real.
A crucial point he mentions is that economic agents’ knowledge is limited and imperfect, and that the marginal cost of gathering further data may well outweigh the marginal benefit we get from this supplementary data. Even if all possible information could be gathered, cognitive abilities are limited and we may not be able to accurately process it. Finally, even if we could process it, data changes all the time and our conclusion could already be invalidated when released. This reminds me of some of the arguments developed by Mises and Hayek in the economic calculation problem in a socialist society. Indeed, central regulation of the banking sector effectively equates to partial central planning of the economic system.
Haldane also describes how modern risk-management models have to deal with several million parameters in order to assess various banking and trading risks and accordingly apply risk-weights to calculate regulatory capital ratios. The problem, he says, is that the pre-crisis way of thinking (both from a regulatory and an economic points of view) hasn’t changed: mathematical models have failed so what is needed is even more complex mathematics…
I don’t agree with everything Haldane says though. I don’t see the need to tax complexity or the even simple need for a regulatory leverage ratio for example. Moreover, Haldane himself admitted that both during the Great Depression and during the Great Recession, “the market was leading where regulators had feared to tread”, as banks took corrective measures to reassure investors. So if markets take the necessary measure by themselves and regulators can’t spot crises, why even have them in the first place?
Here are a few selected quotes:
- “No regulator had the foresight to predict the financial crisis, although some have since exhibited supernatural powers of hindsight.”
- “For what this paper explores is why the type of complex regulation developed over recent decades might not just be costly and cumbersome but sub-optimal for crisis control. In financial regulation, less may be more.”
- “Take decision-making in a complex environment. With risk and rational expectations, the optimal response to complexity is typically a fully state-contingent rule. Under risk, policy should respond to every raindrop; it is fine-tuned. Under uncertainty, that logic is reversed. Complex environments often instead call for simple decision rules. That is because these rules are more robust to ignorance. Under uncertainty, policy may only respond to every thunderstorm; it is coarse-tuned.”
- “The general message here is that the more complex the environment, the greater the perils of complex control. The optimal response to a complex environment is often not a fully state-contingent rule. Rather, it is to simplify and streamline.”
- “Strategies that simplify, or perhaps even ignore, statistical weights may be preferable. The simplest imaginable such scheme would be equal-weighting or “tallying”. In complex environments, tallying strategies have been found to be superior to risk-weighted alternatives. “
- “Complex rules may cause people to manage to the rules, for fear of falling foul of them. They may induce people to act defensively, focussing on the small print at the expense of the bigger picture.”
- “Of course, simple rules are not costless. They place a heavy reliance on the judgement of the decision-maker, on picking appropriate heuristics. Here, a key ingredient is the decision-maker’s level of experience, since heuristics are learned behaviours honed by experience.”
- “As of July this year, two years after the enactment of Dodd-Frank, a third of the required rules had been finalised. Those completed have added a further 8,843 pages to the rulebook. At this rate, once completed Dodd-Frank could comprise 30,000 pages of rulemaking. That is roughly a thousand times larger than its closest legislative cousin, Glass-Steagall. Dodd-Frank makes Glass-Steagall look like throat-clearing. The situation in Europe, while different in detail, is similar in substance. Since the crisis, more than a dozen European regulatory directives or regulations have been initiated, or reviewed, covering capital requirements, crisis management, deposit guarantees, short-selling, market abuse, investment funds, alternative investments, venture capital, OTC derivatives, markets in financial instruments, insurance, auditing and credit ratings.These are at various stages of completion. So far, they cover over 2000 pages. That total is set to increase dramatically as primary legislation is translated into detailed rule-writing. For example, were that rule-making to occur on a US scale, Europe’s regulatory blanket would cover over 60,000 pages. It would make Dodd-Frank look like a warm-up Act.”
- “Einstein wrote that: “The problems that exist in the world today cannot be solved by the level of thinking that created them”. Yet the regulatory response to the crisis has largely been based on the level of thinking that created it. The Tower of Basel, like its near-namesake the Tower of Babel, continues to rise.”
The two following quotes highlight how wrong are those who blame the crisis on ‘deregulation’:
- “Today, regulatory reporting is on an altogether different scale. Since 1978, the Federal Reserve has required quarterly reporting by bank holding companies. In 1986, this covered 547 columns in Excel, by 1999, 1,208 columns. By 2011, it had reached 2,271 columns. Fortunately, over this period the column capacity of Excel had expanded sufficiently to capture the increase.”
- “As numbers of regulators have risen, so too have regulatory reporting requirements. In the UK, regulatory reporting was introduced in 1974. Returns could have around 150 entries. […] Today, UK banks are required to fill in more than 7,500 separate cells of data – a fifty-fold rise. Forthcoming European legislation will cause a further multiplication. Banks across Europe could in future be required to fill in 30-50,000 data cells spread across 60 different regulatory forms.”
Photograph: The Times/Chris Harris