Leverage Ratios Beat the Black Box of Risk-Based Capital

James Chessen makes a strong and fair point that adequate capital alone is not enough to ensure safety and soundness in the banking system ("Leverage Ratios: An Overly Simplistic Capital Measure," May 8). Whatever the measure of minimum capital, whether risk-based or straight leverage, it is true that it will not be enough to prevent banks that consistently take excessive risks from failing. The leverage ratio is intended to be one tool used by regulators and investors in combination with strong bank supervision and market discipline to assess the safety and soundness of banks. 

The leverage ratio was never intended to be used in isolation, to prevent all failures or ignore risk. No one believes the leverage ratio on its own is the solution to the problems that led to the financial crisis. I must confess to being one of those bank supervisors who has a "love affair with the leverage ratio," as Chessen puts it, because it is an understandable measure of a bank's loss-absorption capacity that can be compared across firms. Research and experience suggest that investors cannot understand and do not have confidence in risk-based ratios, especially for the largest banks because these ratios rely on internal risk models. Nor can they be compared across banks because they are based on very different models and risk assumptions. When the risk weights are wrong, whether unintentional or due to gaming, loans and other investments are misallocated.

Capital regulation that puts a primary focus on a leverage ratio does not preclude risk-based capital measures. They still can be used by examiners as measures of relative risks. However, the minimum leverage requirement must be sufficiently binding, so that when used in combination with the imperfect risk-based ratios, the banking industry's insurance fund and taxpayers as the fund's final backstop are protected.

I question the need to worry about the cost of too much capital in the wake of our recent experience with leverage ratios that were much too low and excessive risk-taking, which imposed a tremendous cost on our economy. What we do know is the 30 years of working on risk-based capital with inadequate leverage ratios did not prevent a global financial crisis. 

Esther George is the President and CEO of the Federal Reserve Bank of Kansas City.