Regulators Struggle for Way Forward on Basel III Leverage Ratio

WASHINGTON — Regulators are closely examining whether to lift a proposed leverage ratio as part of a deal to finalize the implementation of Basel III's package of capital and liquidity requirements.

The agencies appear to be at loggerheads over a final deal, according to observers, with the Federal Deposit Insurance Corp. pushing for a higher leverage ratio but facing resistance from the Federal Reserve Board and the Office of the Comptroller of the Currency.

Both FDIC Vice Chairman Thomas Hoenig and Jeremiah Norton have made the case in recent speeches against what they see as the current proposal's overreliance on a risk-based system, endorsing a push for a tougher leverage ratio. Observers said Fed officials are weighing whether to agree to raise the ratio in order to salvage interagency talks.

"The FDIC has the Fed and the OCC over a barrel on Basel III," said Karen Shaw Petrou, managing partner at Federal Financial Analytics Inc. "This comes at a point in which the simmering disputes between the Fed and the OCC, on the one hand, are strongly supportive of a risk-based weighted capital framework and at least two of the three key members of the FDIC Board strongly opposed to it. It has to be settled. I think what you are seeing is the Fed trying to come up with a compromise."

Under the proposal issued by regulators last June, banks would have to keep a 3% leverage ratio, while the largest institutions would face an additional 3% supplemental ratio.

But Hoeing and Norton have argued that requirement is too low, with Hoenig calling for a 10% threshold while Norton has not offered a specific number. They both say that the ratio is insufficient to protect the banking system, noting the banks held just 3% in tangible equity to total assets prior to the financial crisis.

Critics contend that the risk-weighting regime has proven unable to accurately capture risk. The mistrust, observers say, ultimately lies in the internal models used by banks - an argument that's made stronger given recent episodes like JPMorgan Chase & Co.'s multibillion-dollar trading loss.

But even with recognition of its flawed approach, many worry that a more robust leverage ratio would create the wrong incentives for banks and wind up encouraging institutions to take on more risk.

"Leverage should be used as a check on the risk-based approach because of the inherent fallibility of a risk-based approach," said H. Rodgin Cohen, a partner at Sullivan & Cromwell and a leading banking lawyer. "It shouldn't be a separate independent capital requirement."

Hal Scott, a professor of finance at Harvard Law School, agreed, while noting that both approaches that are being debated are troubling.

"I do subscribe to the criticism of the risk-weights," said Scott. "But I think the story of both of these approaches has major issues. The people that are criticizing the risk-weights are not posing an alternative that makes more sense. If you go back to leverage, it makes less sense too; it doesn't get to the riskiness of the asset."

Officials at the Fed and the OCC have refrained from weighing in on the issue publicly, and representatives from both of agencies declined to comment.

As regulators negotiate a final rule, any of the three agencies are allowed to submit proposals for consideration under a joint rulemaking. Regulators indefinitely postponed finalizing Basel III rules in December, saying they needed more time to review thousands of comment letters submitted by industry members. They have, however, hinted that a final package could be delivered in the spring.

Andrew Gray, a spokesman for the FDIC, declined to comment on whether the agency had floated a proposal to other regulators. Representatives from all three agencies said regulators continue to work together on finalizing Basel III for U.S. banks.

Analysts say the FDIC could have the upper hand in the negotiation given that two of its board members have already made their positions clear. If raising the leverage ratio is also backed by FDIC Chairman Martin Gruenberg and Comptroller of the Currency Thomas Curry is convinced on the necessity of raising the standard, the Fed's hand might be forced to strike a final deal given the pressure regulators face internationally to close on a deal.

It's unclear whether either Gruenberg or Curry would be supportive of increasing the leverage ratio at this time, since neither has made any public statements on the matter. (The fifth FDIC board member, Consumer Financial Protection Bureau Director Richard Cordray, is unlikely to take a strong stand on the issue, since it falls outside of consumer issues.)

Observers noted that regulators had been contemplating issues related to leverage for some time given the number of serious questions they posed in the original June proposal.

"Even before all this talk of higher leverage ratios, there were many calibration issues that the U.S. banking regulators had been considering regarding the Basel III leverage ratio, particularly on the denominator," said Andrew Fei, an associate at Davis Polk & Wardwell LLP and a Basel expert.

If past history is any indication, the Fed may await further guidance from the Basel Committee on Banking Supervision. U.S. regulators postponed taking any action on the liquidity coverage ratio until a revised final proposal was issued by the international body, and acted similarly on a global capital surcharge that was applied to the largest banks.

One possibility would be for U.S. bank regulators to repropose the leverage ratio instead of putting it in the final Basel III package. Norton has said he would be opposed to this approach.

Even if regulators agreed to revise the leverage ratio, there is a high chance it would be further revised or recalibrated later. Under the global accord, banks are expected to begin reporting their leverage ratio in 2015, but would not necessarily be subject to the minimum requirement. After some time, supervisors and regulators would examine the information and reassess what the leverage ratio requirement should be and revise it again in 2017.

"There are so many unresolved issues in the denominator of the Basel III leverage ratio it seems unlikely that the U.S. banking regulators would unilaterally finalize that aspect of the U.S. Basel III proposals ahead of any final resolution at the Basel Committee level," said Fei.

Anat Admati, a finance professor at Stanford University and co-author of "The Bankers' New Clothes: What's Wrong with Banking and What to Do About It," argues even with a second look by the Basel Committee, regulators may not go far enough in strengthening the leverage ratio.

"The Basel Committee is looking into risk weights, but they are unlikely to acknowledge that it's a flawed approach," said Admati. "The backstop that they put to an abuse of the risk weights is 3% ratio of equity to total assets, which is outrageously low. One can look at various assessments of risk as a backstop, but equity should be kept at much higher levels if we want a better, more resilient and less distorted system."

Observers see regulators handling the risk-weighting issue as an iterative process, possibly even crafting a Basel 3.5 agreement to tackle the issue of what should be kept in the dominator.

"Basel III did not address risk weightings," said Scott. "Basel III has focused on capital and how do you define it. It has not reexamined risk-weighting. I think we will implement Basel III and be pretty much on time, and Basel 3.5 and risk-weighting will call into question what we're going to have in the denominator and how we do risk weighting."

If regulators agree to raise the leverage ratio, however, they are expected to maintain a risk-weighting regime. Even Hoenig, who has been critical of Dodd-Frank and called on policymakers to scrap Basel III due to its complexity, has endorsed the use of a risk-weighting framework as a form of a backstop.

"The Basel capital standards should be revamped and prioritized using a tangible leverage ratio as the principal measure of capital across banks, across countries," Hoenig said April 29 during a speech in Jakarta. "The risk-weighted standards could be a secondary standard to judge bank concentrations of risk within the overall balance sheet."