A SAFER FINANCIAL SYSTEM IS NOW WITHIN OUR GRASP / THE FINANCIAL TIMES COMMENT & ANALYSIS

December 11, 2013 6:59 pm

A safer financial system is now within our grasp

By Paul Volcker and John Reed

We have come too close to disaster to ignore the obvious lessons, write Paul Volcker and John Reed

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Much has been written about the degree of progress in continuing financial reform. Too little credit, however, has been given to regulators for their efforts to impose a simple, commonsense, leverage restriction on our largest bank holding companies.

We all know the importance of robust capital standards in improving the loss-absorbing capacity of such highly complex, systemically important mega-institutions. In the run-up to the financial crisis, global capital requirements moved to a complex, model-driven approach that grossly understated risk. This aggravated the crisis just when capital support was most needed. Adding a simple leverage ratio – based on the amount of tangible common equity a bank has in relation to its total assets – is an important step towards addressing the weakness of the existing system. The change should reduce the likelihood, and impact, of a big bank failure.

Of all the themes we see in financial crises and failures, one that recurs is leverage – borrowing excessively to enhance returns. While great on the way up for aggressive investing and speculation, it is brutal on the way down. Not only will a highly leveraged business fail faster than a less leveraged one facing equivalent losses, its failure will have a greater systemic impact by transmitting potential losses to its counterparties. Add enough of it, and leverage can turn the safest investment into a recipe for sudden ruin when markets move.

We are pleased that US regulators are moving to apply a stronger leverage ratio in conjunction with a risk-based standard. While international regulators have agreed that leverage ratios of the largest banks should not drop below 3 per cent, US regulators have proposed doubling that to 6 per cent. (In other words, for every $100 in assets, banks must fund at least $6 with common equity.) Critics argue that this could create perverse incentives for banks to seek higher risk/higher yield assets. But such incentives can be addressed by using the standard alongside a robust system of risk weights. As each approach addresses the potential shortcomings of the other, using the two approaches in tandem is a prudent way to go.

The existing “risk-based” capital requirements have a number of shortcomings. Risk weightings are static; risk is dynamic. An asset perceived as safe one day can become risky the next. Regulatory judgments about risk are often tainted by analytic and political biases, incomplete information and the inherent uncertainties of economic forecasting. As a result, rules are overly complicated and filled with exceptions and carveouts that can create perverse incentives to favour certain assets – all while providing a false sense of security.

Adding a strong simple leverage ratio counters many of these shortcomings. It is easy to understand for management, boards, investors – and regulators. It is also comparable across companies, and in conjunction with a standardised risk-based system, difficult to game. A dual approach dramatically improves transparency about a company’s risk exposure and should allow investors and counterparties to perform apples-to-apples comparisons among large, complex institutions.

There is, however, one important caveat. In addition to raising the standards, as we on the Systemic Risk Council and other public interest groups have argued, one way to improve this approach is to fix our accounting regime to allow apples-to-apples comparisons between US institutions and their global counterparts.

Regulators have done a good job of trying to establish a leverage test to account for off-balance-sheet items given differences between US and international accounting standards, but convergence would be far superior. Many readers would be surprised just how leveraged many US institutions are, using the international standards.

The door to a safer, less leveraged financial system is half-open. We can open it wide by uniting standardised risk-based capital rules with leverage constraints, and common balance- sheet measures through convergence on global accounting standards.


The writers are former chairman of the Federal Reserve Board, and former chairman and chief executive of Citicorp and Citibank. Both are members of the Systemic Risk Council

Copyright The Financial Times Limited 2013.