Photo: Business Insider
In Part 1 of “The Glass-Steagall Debate Doesn’t Matter,” I made the case that – regardless of where the public debate stands on reinstituting Glass-Steagall – the chances of that are very slim, absent another financial meltdown.But what DOES very much matter is what this debate represents: it is part of a broader public discussion of how much risk big banks should be taking. Glass-Steagall represents one means to the end of reducing that risk, along with the Volcker Rule (to prohibit banks from proprietary trading) and the UK retail-deposit-ring-fencing. And of course, part and parcel of this debate is how much capital the banks should have as a cushion for that risk.
Fair enough. But the recognition is growing that the methodologies regulators are using to determine that capital are flawed. The Basel regimes are an ever-more-complicated series of capital constructs, in which banks measure and gauge their own risk (!) and in which opportunities for capital arbitrage are significant. (A 0% risk weighting for government bonds is one example; who thinks Greek government risk is 0??)
Thus, the solution increasingly being put forth is for a backstop through the use of the old-fashioned leverage ratio: the ratio between a bank’s capital and its assets. The ratio is simple, less-game-able and, research has shown, it was a better indicator of banks’ ability to weather the financial crisis than the much-more-“sophisticated” and complex Basel capital ratios.
But besides the drive for “higher” leverage ratios, there is no consensus around what the “right” number is. Going into the crisis, some firms had $40+ of assets for every $1 of equity. The Basel regime calls for a minimum of $33 of assets to equity; big US banks now average a ratio of 13.5 times; and former FDIC Chair Sheila Bair has called for a ratio of 12 to 1.
Better, certainly. But what do these ratios actually mean?
In the most conservative of those above, a 12:1 assets to equity ratio mathematically means that a loss equating to about 8% of net assets wipes out equity. (In reality, the decline that would bring a bank down would be less than that, because bank funding would dry up – including in the form of “runs on the bank” by depositors – long before the equity goes to $0.) And for the Basel minimum, it’s a loss of just 3% of net assets before equity is gone.
Feel better now??? I didn’t think so.
The lessons learned during the financial melt-down should not be forgotten. Thus, the national debate we are having should be expanded to include this: How safe do these proposed leverage ratios make the banks? Under what circumstances would this be insufficient? How often has that occurred in the past? How safe should safe be? And what is the price for that greater safety, because there is a price?
In the meantime, perhaps the most important initiative US regulators have undertaken are the new bank stress tests, which look at how banks perform in tough economic scenarios. These tests represent a good start; they are an important undertaking to avert the next banking collapse; and they need to be strengthened even further. More to come on this topic……
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