FDIC Approves A Simple Leverage Ratio To Improve Capital Adequacy Standards

Bank regulators vote to strengthen the leverage capital requirements for the eight largest banking organizations by taking an approach the cooperative model has used for more than 100 years.

During the FDIC’s April 8, 2014, board meeting, the Bank Insurance Fund approved a new rule to strengthen the leverage capital requirements for the eight largest, most systematically important banking organizations.

The new rule requires a 6% leverage ratio for the insured banks to be considered well-capitalized under prompt corrective action. Bank holding companies would need to have a leverage ratio of 5%. By comparison, the Basel framework requires only a 3% minimum leverage ratio for both levels of a banking organization.

This comes at a time when the NCUA is proposing a new risk-based capital rule, a rule similar to the one all three banking regulators have found to be inadequate. The Federal Reserve, OCC, and FDIC are requiring a simple leverage ratio test for the most important and largest institutions. This has been the cooperative model for more than 100 years.

As the banking regulators unanimously conclude risk-based capital is an insufficient way to measure capital adequacy, the most important question is: Why would NCUA impose this failed system on credit unions?

Most Significant Step

During Tuesday’s meeting, FDIC chairman Martin J. Gruenberg said the leverage approach benefits the financial system as a whole and reduces the potential systemic risk these institutions pose. He supported the cooperative model’s capital standard saying: This is a rule of significant consequence. In my view, this final rule may be the most significant step we have taken to reduce the systemic risk posed by these large complex banking organizations.

In a more extensive statement, FDIC vice chairman Thomas M. Hoenig laid out the benefits of a leverage ratio versus the traditional risk-based approach: The supplementary leverage ratio is a more reliable measure that is simple to calculate, understand, and enforce than the subjective risk-weighted measures, and it provides a highly useful initial assessment of a bank’s balance sheet strength.

He continues later in the statement: Experience has shown that relying only on a risk-based capital measure serves the public poorly … As recently as year-end 2013, reported risk-based capital ratios for the largest global banks averaged 13% while the average leverage ratio was less than 5% … .

Hoenig went on to express his belief in the leverage ratio: I am confident that supervisors will rely increasingly on the leverage ratio, as the market already does, to judge a firm’s capital levels, loss absorbing capacity, and balance sheet strength (emphasis added).

A third FDIC board member, Jeremiah O. Norton, supported the rule with the following points: There is recent economic research to support the conclusion that the leverage ratio is a statistically significant predictor of bank default while the Basel Tier I risk-based capital ratio is not.

Banks with higher leverage ratios maintained the supply of credit during the crisis more than their peers, Norton said, citing research by the staff of the International Monetary Fund.

The Cooperative Model Proves The Leverage Ratio Works

The three banking regulatory agencies did not specifically reference the cooperative model, but their arguments are all supported by the credit union system’s performance during the Great Recession. The net-worth leverage ratio is simple to calculate, easy to understand, and readily comparable across organizations. It also enables credit unions to keep lending.

In summary, the cooperative leverage model for capital adequacy works. The risk-based model, now in its third edition with Basel III, is inadequate as a means for regulators to measure capital sufficiency. Why impose a failed system on cooperatives?

April 10, 2014

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