The major flaw in big banks' argument against the leverage ratio

Excessive leverage was a primary cause of the financial crisis, and yet big banks and even some government officials appear eager to relax rules that limit leverage at the largest U.S. financial institutions. But banks’ argument for why such reform is necessary doesn’t hold water.

Large banks say the risk-insensitive nature of the Basel III Supplemental Leverage Ratio (SLR) restricts market liquidity by increasing banks’ cost of holding so-called safe securities and derivatives for market-making activities. A proposed change to the leverage ratio would remove those assets from the SLR calculation. But the proposed change would allow more leverage which could amplify the alleged liquidity problem.

The Basel III SLR regulation, finalized in 2014, put a limit on large banking organization leverage by requiring banking organizations with over $250 billion in assets to meet a new capital threshold that treats all holdings with an equal risk weighting. The SLR requirement must be met in addition to banks’ risk-based capital requirements. The eight U.S. "global systemically important banks" (G-SIBs) must meet an enhanced SLR of 5% at the holding company and 6% percent at the subsidiary bank level. The SLR rules take effect in 2018.

Mopic/Mopic - stock.adobe.com

The SLR is the ratio of an institution’s Tier 1 capital to its “total leverage exposure.” Total leverage exposure equals a holding company’s consolidated assets plus exposures from derivatives, repurchase agreements, securities lending, lines of credit, guarantees and other off-balance activities that contributed to the excessive leverage that imperiled many institutions in the recent financial crisis. All eight G-SIBs currently meet the 5% minimum SLR, but many of them could not satisfy the requirement in the most recent Federal Reserve stress test.

The case for relaxing the SLR has been championed by The Clearing House, the trade organization for the U.S. G-SIBs. Writing for The Clearing House, Stanford University professor Darrell Duffie argued that the imposition of Dodd-Frank Act reforms, including the SLR, has led to higher costs for holding securities and therefore a reduction in securities inventories of the G-SIBs. G-SIBs are also imposing internal “funding value adjustments” on market-making and derivatives activities to reflect their effect on “total leverage exposure” in the SLR. This works like a surcharge, reducing liquidity by raising the bid-asked spread that a G-SIB requires to complete a transaction.

The recent Treasury Department report with recommendations for changing the regulatory framework sides with The Clearing House. Because leverage ratios are not risk-sensitive, Treasury claims they encourage G-SIBs to choose risky activities instead of providing customers access to safe central clearing derivatives trades and secured repurchase agreement financing. The Treasury’s solution is to deduct the institutions’ holding of central bank reserves, U.S. Treasury securities and initial margin for centrally cleared derivatives, from the SLR’s total leverage exposure. This is equivalent to risk-weighting the SLR components and setting some weights to zero.

Using regulatory data, my estimates suggest that these changes could increase the SLR reported by some G-SIBs by more than 1.5 percentage points — or the equivalent of gaining roughly $40 billion in new Tier 1 capital — just by making a few “minor” technical changes to the SLR calculation.

Make no mistake, the Treasury’s proposed SLR rule change would allow G-SIBs to increase their leverage. And this is why the large banks’ argument in favor of changing the SLR is so thin.

Typically, the cost — and therefore the profitability — of an investment does not depend on how it is financed. This was the finding of the Nobel Prize-winning economists Franco Modigliani and Merton Miller in their famous capital structure theorem. Yet the theorem may not apply when there are distortions at play.

Duffie’s article for The Clearing House argues that the distortion inhibiting G-SIBs from providing liquidity is the so-called debt overhang problem. Put simply, debt overhang occurs when a company has so much outstanding debt that it alters bank incentives so that management only approves investments that will not reduce the risk of its future profit stream. Profitable but safe investments will be rejected because the profits from these investments are more likely to be used to pay off debt holder claims than to yield shareholders a dividend or capital gain.

Here lies the Achilles' heel of the Clearing House argument. If the debt overhang problem is the cause of diminished G-SIB participation in safe market-making and derivatives activities, then how can the correct solution be to replace the current SLR with a risk-weighted SLR requirement that allows G-SIBs to increase their leverage? Higher G-SIB leverage will only make the debt overhang problem worse, not better. The Treasury’s proposed changes to the SLR calculation will not restore the incentive for banks to get back into safe market-making activities.

If a debt overhang problem is really causing G-SIBs to reduce their participation in providing “safe” liquidity, the solution is not to replace the SLR; the solution is to reduce the debt overhang problem by reducing G-SIB leverage.