Download PDF In the past two weeks several events have emphasized the need for a simple and reliable measure of capital adequacy at large banks, which does not rely on risk-weighting assets and is less susceptible to manipulation:
1. The earnings reports of large banks revealed a decline in the size of risk-based assets that appear to be largely a result of modeling revisions;
2. A report of the Basel Committee on Banking Supervision showed a wide variation in capital requirements for similar risks in large banks’ trading books which is largely attributable to modeling issues; and
3. Recently announced delays in the implementation of Basel III with the EU seeking to delay the reporting of the Basel III comprehensive leverage measure beyond the January 2015 deadline.
The intent of Basel III is to strengthen banks’ ability to absorb losses. In the absence of a strong leverage ratio requirement, the large banks’ ability to use their own models to whittle down their minimum capital requirements defeats this goal. The Shadow Committee urges that U.S. regulators to move promptly to implement an improved leverage requirement, while demanding a ratio substantially above the 3 percent agreed to by the Basel Committee. Many experts including current and former banking regulators have suggested a figure north of 10 percent would be appropriate.
The Federal Reserve has two upcoming opportunities to employ an improved leverage standard. First, the Federal Reserve can include the Basel III leverage requirement in the rule that sets higher prudential standards for large bank holding companies and should establish a process for early remediation actions, a large bank fails to meet the Basel III leverage requirement. Second, the Federal Reserve is about to disclose the results of the Comprehensive Capital Analysis and Review (CCAR), which is becoming the Federal Reserve Board’s central tool of capital supervision. Unfortunately, the Fed’s template for reporting the CCAR results continues to emphasize risk-weighted capital ratios. It is unclear why the Fed intends to use risk-based ratios as the primary measure of banks’ capital strength given the well-documented inaccuracy of risk weights. Using risk-based ratios creates a highly misleading impression of banks’ capital strength.
The Fed also chooses a misleading leverage standard. Choosing an appropriate standard is complicated by a number of factors involving both the numerator and the denominator of the leverage ratio. The objective is to show what percentage of an institution’s total risk exposure is funded by equity that can absorb losses on a going concern basis. For bank holding companies, this involves a choice of rules for consolidating affiliated entities and many decisions about accounting standards and how to apply them. Particularly worrisome is the issue of how to incorporate off-balance sheet activities into the measure of total exposure.
How the numerator and the denominator are defined can make a substantial difference in the apparent strength of a bank’s capital position. For example, the Fed has chosen Tier 1 capital as the numerator. This is broader than the amount of capital that can be relied upon to sustain the institution as a going concern. Tangible common equity is a better reflection of a bank’s ability to withstand a period of stress. To illustrate the significance of this choice, tangible common equity versus Tier 1 capital has a marked impact on the ratio. Citigroup shows Tier 1 capital of $141 billion, but tangible equity of only $98 billion. The Tier 1 numerator overstates Citigroup’s ability to absorb loss and remain a going concern.1
The Fed’s leverage standard also tends to understate the denominator because it neglects off-balance sheet exposures. The Basel Committee has worked through these issues carefully and published a definition that is superior to the standard that the Fed plans to us in its upcoming CCAR disclosures. In particular, the Basel approach carefully integrates off-balance sheet positions into the total exposure measure. For example, Morgan Stanley reports total assets of $749 billion, but if its total exposure (including off-balance-sheet positions) is reported according to International Financial Reporting Standards (IFRS) its total exposure is $1.82 trillion. The leverage ratio counting only on-balance- sheet assets is 6.22%, but including off-balance sheet exposures, it drops to 2.52%. Granted, IFRS may be overly inclusive in its reflection of off-balance sheet risks. Nonetheless, this example demonstrates how extreme the impact can be and makes it easier to compare US banks’ leverage with that of their European counterparts.
Taking into account the appropriate definition of capital and IFRS’ more inclusive measure of off-balance-sheet risks, the leverage ratios for Citigroup and Morgan Stanley become much smaller. Using Tier 1 as the numerator and only on-balance sheet assets in the denominator Citigroup’s ratio is 7.42% and Morgan Stanley’s is 6.22% But substituting Tier 1 Capital and the more inclusive measure of exposure, Citigroup’s ratio falls to 5.37% and Morgan Stanley’s falls to 2.52%
The Shadow Committee believes that the Basel leverage ratio is a more accurate indicator of the capital strength of banks and should supplant the opaque, difficult-to-verify risk-weighted denominator that proved so unreliable during the crisis. We encourage the Basel Committee to adopt tangible common equity in the numerator rather than Tier 1 capital. The Basel Committee is currently examining this possibility.
The Fed could advance the cause of transparency in reporting capital adequacy and improve market discipline by requiring that banks report their CCAR results using a leverage ratio that employs tangible common equity in the numerator and also incorporates more off-balance sheet exposures through use of the internationally- agreed Basel III approach in defining the denominator.