Q. There are a lot of news stories lately about limitations on bank leverage – Basel III was just approved by the Fed, and now US regulators also started talking about a different set of borrowing limitations. How do these things compare?
A. Yes, it’s a bit confusing. First of all, Basel III is a set of standards promulgated by the Bank of International Settlements. The Fed OK’d imposition of those standards on US banks– with some eyebrow-raising exceptions, like being more liberal for real estate lending. So this is the basic international standard for banks, and the key point is that it’s a “risk based” system.
Q. So banks have to categorize their various positions by how risky they are, and the amount of capital they have to hold depends on that.
A. Right. Sounds logical, but there are lots of huge issues in practice. For example, sovereign debt is assigned a risk weighting of zero– an idea that doesn’t seem exactly right anymore. Moreover, the risk models the banks use do not produce uniform results. The BIS estimated that the same set of assets could result in regulatory capital ratios of between 5 and 15%, depending on the risk model used.
Q. So, then, what’s the response?
A. The new idea is a “generally applicable leverage ratio” for the TBTF banks that compares total assets– regardless of risk– to Tier 1 capital. The proposal is for a 5% minimum ratio at the holding company level, and a 6% ratio at the deposit-taking subsidiary with the FDIC insurance.
Q. And what would the impact of that really look like?
A. Well early estimates say that JPMorgan and Morgan Stanley would, for example, need to raise another $15 billion or so. Many folks are hoping, frankly, that these kinds of rules will incent some of the biggest banks to shrink and therefore pose less of a risk to taxpayers. They might.