53044 NOTE NUMBER 11 PUBLIC POLICY FOR THE PRIVATE SECTOR DECEMBER 2009 The Leverage Ratio FINANCIAL AND PRIVATE SECTOR DEVELOPMENT VICE PRESIDENCY Katia D'Hulster A New Binding Limit on Banks Katia D'Hulster E xce ssive le ver a g e b y b a nk s is wid e ly b e lie v e d t o ha v e c o n t r i b u t e d t o (kdhulster@worldbank .org) is a senior financial the glob al f ina nc ia l c r is is . T o a d d r e s s t his , t he int e r na t io n a l sector specialist in the community ha s p r o p o s e d t he a d o p t io n o f a no n- r is k - b a s e d c a p i t a l Financial Systems measure , the l e v e r a g e r a t io , a s a n a d d it io na l p r ud e nt ia l t oo l t o Department of the World Bank. comp le me nt minim um c a p it a l a d e q ua c y r e q uir e m e nt s . I t s a d o p t i o n can re d uce the r is k o f e x c e s s iv e le v e r a g e b uild ing up in in d i v i d u a l This is the 11th in a series of policy briefs on entities and in t he f ina nc ia l s y s t e m a s a who le . T he le v e r a g e r a t i o the crisis--assessing the has inhe rent lim it a t io ns , ho we v e r , a nd s ho uld t he r e f o r e b e c o n s i d e r e d policy responses, shedding light on financial reforms as just one of a s e t o f m a c r o - a nd m ic r o - p r ud e nt ia l p o lic y t o o l s . currently under debate, Excessive leverage by banks is widely believed assets exceed its equity base, its balance sheet is and providing insights to have contributed to the global financial crisis said to be leveraged. Banks typically engage in for emerging-market policy (FSB 2009; FSA 2009). As a result, the G-20 and leverage by borrowing to acquire more assets, with makers. the Financial Stability Board have proposed the the aim of increasing their return on equity. introduction of a leverage ratio to supplement Banks face economic leverage when they are risk-based measures of regulatory capital.1 exposed to a change in the value of a position by more than the amount they paid for it. A What is leverage? typical example is a loan guarantee that does Leverage allows a financial institution to increase not show up on the bank's balance sheet even THE WORLD BANK GROUP the potential gains or losses on a position or though it involves a contingent commitment that investment beyond what would be possible may materialize in the future. through a direct investment of its own funds. Embedded leverage refers to a position with There are three types of leverage--balance sheet, an exposure larger than the underlying mar- economic, and embedded--and no single mea- ket factor, such as when an institution holds a sure can capture all three dimensions simulta- security or exposure that is itself leveraged. A neously. The first definition is based on balance simple example is a minority investment held by sheet concepts, the second on market-dependent a bank in an equity fund that is itself funded by future cash flows, and the third on market risk. loans. Embedded leverage is extremely difficult Balance sheet leverage is the most visible and to measure, whether in an individual institu- widely recognized form. Whenever an entity's tion or in the financial system. Most structured THE LEVERAGE RATIO A NEW BINDING LIMIT ON BANKS credit products have high levels of embedded As with regulatory capital measures, the leverage, resulting in an overall exposure to loss leverage ratio generally applies at the level of that is a multiple of a direct investment in the the individual bank as well as on a consolidated underlying portfolio. Two-layer securitizations or basis. How the ratio is actually calculated and resecuritizations, such as in the case of a collater- monitored will therefore usually be aligned with alized debt obligation that invests in asset-backed the scope of prudential consolidation practiced securities, can boost embedded leverage to even in a jurisdiction. higher levels.2 Who uses a leverage ratio? 2 Measures of leverage Three countries with large international banking The most widely used measure of leverage for reg- systems are either using a leverage ratio or have ulatory purposes is the leverage ratio. Leverage announced plans to do so. The United States and can also be expressed as a leverage multiple, which Canada have maintained a leverage ratio alongside is simply the inverse of the leverage ratio. risk-based capital adequacy requirements, while The leverage ratio is generally expressed as Switzerland has announced the introduction of a Tier 1 capital as a proportion of total adjusted leverage ratio that will become effective in 2013. assets. Tier 1 capital is broadly defined as the sum Other countries will probably also adopt this tool. of capital and reserves minus some intangible These countries may use a leverage ratio for both assets such as goodwill, software expenses, and micro- and macro-prudential purposes--for exam- deferred tax assets.3 In calculating the leverage ple, as a maximum leverage limit for supervised ratio, these intangibles have to be removed from entities, an indicator for monitoring vulnerability, the total asset base as well, to make it comparable or a trigger for increased surveillance or capital to Tier 1 capital (figure 1). requirements under Pillar 2 of the Basel II capital The leverage ratio can thus be thought of accord. as a measure of balance sheet or, to the extent Among the three countries, the United States that it also includes off-balance-sheet exposures has the simplest leverage ratio, expressed as a (Breuer 2000), economic leverage. As a result minimum ratio of Tier 1 capital to total average of differences in accounting regimes, balance adjusted assets (defined as the quarterly average sheet presentation, and domestic regulatory total assets less deductions that include goodwill, adjustments, however, the measurement of lever- investments deducted from Tier 1 capital, and age ratios varies across jurisdictions and banks. deferred taxes). The leverage ratio is set at 3 Accounting regimes lead to the largest variations. percent for banks rated "strong" (those that pres- In particular, the use of International Financial ent no supervisory, operational, and managerial Reporting Standards results in significantly weaknesses and are therefore rated highly under higher total asset amounts, and therefore lower the supervisory rating system) and at 4 percent leverage ratios for similar exposures, than does for all other banks. Banks' actual leverage ratios the use of U.S. generally accepted accounting are typically higher than the minimum, however, principles. The reason is that under International because banks are also subject to prompt correc- Financial Reporting Standards netting conditions tive action rules requiring them to maintain a are much stricter and the gross replacement value minimum leverage ratio of 5 percent in order to of derivatives is therefore generally shown on be considered well capitalized. The U.S. leverage the balance sheet, even when positions are held ratio applies on a consolidated basis (at the level under master netting agreements with the same of the bank holding company) as well as at the counterparty. level of individual banks, but it does not take into account off-balance-sheet exposures. A higher Figure How the leverage ratio is calculated ratio may be required for any institution if war- ranted by its risk profile or circumstances. 1 Equity Reserves Total assets Intangible assets Intangible assets Tier 1 capital/Adjusted assets Tier 1 capital Adjusted assets Leverage ratio The larger U.S. investment bank holding com- panies and their subsidiaries were regulated by the Securities and Exchange Commission and thus were not subject to a leverage limit.4 Instead, there Note: Intangible assets include goodwill, software expenses, and deferred tax assets. were restrictions at the level of the individual firm on the amount of customer receivables the invest- age ratio, with an expansive definition of assets ment bank could hold as a multiple of capital (net and a conservative definition of capital, as a capital rule). Only two of the five investment bank supplementary binding measure to the Basel II holding companies originally affected by this rule risk-based framework (BCBS 2009). still exist (Goldman Sachs and Morgan Stanley), however, and they have now been converted into Benefits of the leverage ratio bank holding companies. Introducing the leverage ratio as an additional The Canadian "assets to capital multiple" is a prudential tool has several potential benefits. more comprehensive leverage ratio because it also measures economic leverage to some extent. It is A countercyclical measure applied at the level of the consolidated banking The financial crisis has illustrated the disrup- group by dividing an institution's total adjusted tive effects of procyclicality (amplification of the consolidated assets--including some off-balance- effects of the business cycle) and of the risk that sheet items5--by its consolidated (Tier 1 and 2) can build up when financial firms acting in an capital. Under this requirement total adjusted individually prudent manner collectively create assets should be no greater than 20 times capi- systemic problems. There is now broad consen- tal, although a lower multiple can be imposed sus that micro-prudential regulation needs to be for individual banks by the Canadian supervi- complemented by macro-prudential regulation sory agency, the Office of the Superintendent that smooths the effects of the credit cycle (FSA of Financial Institutions (OSFI). This is more 2009; Andritzky and others 2009). This has led conservative than the U.S. leverage ratio--and to proposals for countercyclical capital require- the inclusion of off-balance-sheet items strength- ments and loan loss provisions that would be ens the ratio even more. Indeed, the stringency higher in good times and lower in bad times. of Canada's leverage ratio has been cited as one The leverage ratio is versatile enough to factor--along with sound supervision and regu- be used both as a macro- or micro-prudential lation, good cooperation between regulatory policy tool and as a countercyclical instrument. agencies, strict capital requirements, and con- Intuitively, one would expect that in a fair-value servative lending practices--contributing to the environment a rise in asset prices would boost strong performance of its financial sector during bank equity or net worth as a percentage of total the financial crisis (IMF 2009). assets. Stronger balance sheets would result in a In 2008 the Swiss regulator FINMA, in strength- lower leverage multiple. Conversely, in a down- ening capital adequacy requirements, introduced turn, asset prices and the net worth of the institu- a minimum leverage ratio under Pillar 2 of Basel II tion would fall and the leverage multiple would solely for Credit Suisse and UBS. The Swiss lever- be likely to increase (table 1). age ratio is based on Tier 1 capital as a proportion Contrary to intuition, however, empirical evi- of total adjusted assets and is set at a minimum of dence has shown that bank leverage rises during 3 percent at the consolidated level and 4 percent boom times and falls during downturns. Leverage at the individual bank level. For the calculation is said to be procyclical because the expansion of this new benchmark, the balance sheet under and contraction of balance sheets amplify rather International Financial Reporting Standards is than counteract the credit cycle. The reason is adjusted for a number of factors, the most note- that banks actively manage their leverage dur- worthy being the deduction of the entire domes- ing the cycle using collateralized borrowing and tic loan book (the Swiss authorities presumably lending. When monetary policy is "loose" relative wanted to ensure that introducing the leverage to macroeconomic fundamentals, banks expand ratio would not hamper expansion of the domes- their balance sheets and, as a consequence, the tic credit market). Other adjustments are more supply of liquidity increases. In contrast, when common, such as exclusion of the replacement monetary policy is "tight," banks contract their values of derivatives to reduce the effects of the balance sheets, reducing the overall supply of strict netting rules under International Financial liquidity (see Adrian and Shin 2008). Reporting Standards. To reduce procyclicality, banking supervisors The Basel Committee on Banking Supervision can limit the buildup of leverage in an upturn by has recently proposed the introduction of a lever- setting a floor on the leverage ratio or a ceiling Table Hypothetical movements of a leverage multiple or ratio in a fair-value environment 1 Leverage multiple Leverage ratio (%) Starting point Adjusted assets: 100 Tier 1: 4 25 4 Upturn in credit cycle Adjusted assets: 100 3 103 Tier 1: 4 3 7 14.7 6.8 Downturn in credit cycle 4 Adjusted assets: 100 2 98 Tier 1: 4 2 2 49 2.04 on the leverage multiple. The leverage ratio limit as those under Basel I or II, may thus encour- could also be expressed as a range with a long-term age banks to build up relatively riskier balance target level. Alternatively, there could be a mecha- sheets or expand their off-balance-sheet activity. nism to relax the limit during downturns, since con- Moreover, because of the crude calculation of the stant fixed caps on the leverage ratio (or constant leverage ratio, prudent banks holding substantial fixed floors on the leverage multiple) could amplify portfolios of highly liquid, high-quality securities procyclicality by encouraging banks to deleverage may argue that they are being punished for their during a downturn (and vice versa). conservatism. Less regulatory arbitrage Limited to balance sheet leverage The greater risk sensitivity of Basel II capital require- One argument against the leverage ratio has been ments can result in a perverse incentive for financial that the United States, despite having a leverage institutions to structure products so that they qualify ratio in place, was at the epicenter of the global for lower capital requirements. When this incentive financial crisis. Why did the U.S. leverage ratio is collectively exploited, the system is likely to end up fail to provide the right warning signs? To answer with high concentrations of structured exposures this question, a good starting point is to analyze subject to low regulatory capital requirements. A the evolution of leverage in the years running minimum leverage ratio, among other measures, up to the financial crisis. can help dampen this perverse incentive by acting Over the past decades financial innovation as a backstop to risk-based capital requirements has fundamentally changed the structure of (Hildebrand 2008). Moreover, it can be customized the financial system. This trend is exempli- to individual banks' risk profiles. fied by credit risk transfer instruments such as structured credit products, through which Simplicity portfolios of credit exposures can be sliced The leverage ratio is simple to apply and monitor. and repackaged to meet the needs of investors. As a result, it can be adopted quickly and without Banks funded a growing amount of long-term leading to high costs or requirements for exper- assets with short-term liabilities in wholesale tise for banks or their supervisors. Moreover, the markets through the use of off-balance-sheet leverage ratio can be applied regardless of the vehicles, exposing themselves to credit and capital adequacy regime in a jurisdiction. liquidity risk by providing facilities to these vehicles. Moreover, they also held structured Limitations of the leverage ratio credit instruments on their own balance sheet, While the leverage ratio offers benefits, it is also exposing themselves to embedded leverage and subject to several weaknesses that policy makers increasing their asset-liability mismatch and need to take into account. their funding liquidity risk. For major European and U.S. investment Wrong incentives banks, balance sheet leverage multiples (mea- The leverage ratio does not distinguish different sured as total assets divided by equity) increased types of bank assets by their riskiness and, in the during the four years preceding the global finan- absence of risk-based capital requirements such cial crisis (figure 2). For Japanese and U.S. com- mercial banks, by contrast, aggregate balance makers need to be cognizant of the inherent limi- sheet leverage did not increase over this period, tations and weaknesses of the leverage ratio. and in some instances it even fell. The proposals at an international level to As can be deduced, the balance sheet lever- supplement risk-based measures with an inter- age ratio did not adequately reflect the trends in nationally harmonized and appropriately cali- financial innovation because significant leverage brated leverage ratio are welcome and could lead was assumed through economic and embedded to its adoption by a wide range of countries in leverage, which is not recorded on the balance the future. A leverage ratio cannot do the job sheet. In addition, factors not captured by the alone; it needs to be complemented by other 5 leverage ratio or by risk-based capital require- prudential tools or measures to ensure a com- ments also contributed to the crisis, such as weak prehensive picture of the buildup of leverage underwriting standards for securitized assets and in individual banks or banking groups as well as the buildup of such risks as funding liquidity risk. in the financial system. Additional measures to As a result, the extent of leverage accumulated provide a comprehensive view of aggregate lever- in the financial system in recent years has only age, including embedded leverage, and to trigger recently become visible. enhanced surveillance by supervisors need to be developed. Conclusion There appears to be consensus that no single tool or measure would have prevented the finan- cial crisis and that an adequate policy response Notes requires a menu of macro- and micro-prudential The author would like to thank Damodaran Krishna- policy tools. The leverage ratio can be a useful murti for his input on an earlier version and Constan- prudential tool, and one that can be relatively tinos Stephanou, Joon Soo Lee, Cedric Mousset, Tom easy to implement, for jurisdictions that do not Boemio, and David Scott for their valuable comments want to rely solely on risk-sensitive capital require- and suggestions. ments--though it is no silver bullet. Combining 1. For example, the G-20 Declaration of April 2009 on the leverage ratio with Basel-type capital rules can Strengthening the Financial System states that "risk- reduce the risk of excessive leverage building up based capital requirements should be supplemented in individual entities and in the system as a whole. with a simple, transparent, non-risk based measure As the financial crisis showed, however, policy which is internationally comparable, properly takes Figure Bank balance sheet leverage multiples, 1995­2008 (second quarter) 2 Balance sheet leverage multiple 50 Balance sheet leverage multiple 50 40 40 Continental Europee Japand 30 30 World top 50 20 U.S. investmentb 20 U.S. commerciala United Kingdomc 10 10 1995 2000 2005 2008Q2 1995 2000 2005 2008Q2 Source: CGFS 2009. Note: Balance sheet leverage multiple (total assets divided by total equity) of individual banks weighted by asset size. a. Bank of America, Citigroup, JPMorgan Chase, Wachovia Corporation, Washington Mutual, and Wells Fargo & Company. b. Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley. c. Barclays, HSBC, Lloyds TSB Group, and Royal Bank of Scotland. d. Mitsubishi UFJ Financial Group, Mizuho Financial Group, and Sumitomo Mitsui Financial Group. e. ABN AMRO Holding, Banco Santander, BPN Paribas, Commerzbank, Crédit Agricole, Credit Suisse, Deutsche Bank, Société Générale, UBS, and UniCredit SpA. THE LEVERAGE RATIO A NEW BINDING LIMIT ON BANKS into account off-balance sheet exposures, and can help Breuer, P. 2000. "Measuring Off-Balance Sheet Lever- contain the build-up of leverage in the banking system." age." IMF Working Paper 00/202, International Similarly, the Financial Stability Board report on procy- Monetary Fund, Washington, DC. clicality (FSB 2009, p. 2) recommends that "the Basel CGFS (Committee on the Global Financial System). Committee should supplement the risk-based capital 2009. The Role of Valuation and Leverage in Procyclical- requirement with a simple, non-risk based measure to ity. CGFS Papers, no. 34. Basel: Bank for Interna- crisisresponse help contain the build-up of leverage in the banking tional Settlements. system and put a floor under the Basel II Framework." FSA (U.K. Financial Services Authority). 2009. The The views published here 2. The Joint Forum (2005) analyzed the embedded Turner Review: A Regulatory Response to the Global Bank- are those of the authors and leverage in the tranches of a hypothetical collateralized ing Crisis. London. should not be attributed debt obligation exposed to a portfolio of corporate FSB (Financial Stability Board). 2009. Report of the to the World Bank Group. bonds. In that example the leverage of the junior Financial Stability Forum on Addressing Procyclicality in Nor do any of the conclusions tranches was about 15 times that of the underlying the Financial System. Basel. represent official policy of portfolio, while the leverage of the most senior tranches Hildebrand, P. M. 2008. "Is Basel II Enough? The Ben- the World Bank Group or was between a third and a tenth of that of the underly- efits of a Leverage Ratio." Financial Markets Group of its Executive Directors or ing portfolio. Lecture, London School of Economics, London, the countries they represent. 3. The audited profit for the year can be included in December 15. Tier 1 capital, while the loss for the year must always IMF (International Monetary Fund). 2009. "Canada: To order additional copies be deducted, regardless of whether it is audited or not. Article IV Consultation." Country Report 09/162, contact Suzanne Smith, Intangible assets are deducted from capital and reserves Washington, DC. managing editor, because of their more abstract and subjective nature. Joint Forum. 2005. "Credit Risk Transfer." Basel Com- The World Bank, 4. A leverage restriction is in place for smaller broker mittee on Banking Supervision, Basel. 1818 H Street, NW, dealers that, unlike the bigger investment banks, do not Washington, DC 20433. carry customer accounts. Such broker dealers must not have aggregate indebtedness exceeding 15 times their Telephone: net capital. In addition, a broker dealer must file a no- 001 202 458 7281 tice with the Securities and Exchange Commission if its Fax: aggregate indebtedness exceeds 12 times its net capital. 001 202 522 3480 5. Off-balance-sheet items for this ratio are direct credit Email: ssmith7@worldbank.org substitutes, including letters of credit and guarantees, transaction- and trade-related contingencies, and sale Produced by Grammarians, Inc. and repurchase agreements. They are included at their notional amount. Securitized assets are not included as Printed on recycled paper off-balance-sheet items of the sponsor or originator and thus would not be taken into account in the leverage ratio. References Adrian, T., and H. S. Shin. 2008. "Liquidity, Monetary Policy and Financial Cycles." Current Issues in Econom- ics and Finance (Federal Reserve Bank of New York) 14 (1). Andritzky, J., J. Kiff, L. Kodres, P. Madrid, A. Maechler, N. Sacasa, and J. Scarlata. 2009. "Policies to Mitigate Procyclicality." IMF Staff Position Note 09/09, Inter- national Monetary Fund, Washington, DC. BCBS (Basel Committee on Banking Supervision). 2009. Strengthening the Resilience of the Banking Sector. Consultative Document. Basel. This Note is available online: http://rru.worldbank.org/PublicPolicyJournal