Bank of England: the future for bank solvency metrics

Author: | Published: 23 May 2013
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Interview transcript

Q: Where's the debate going with regards to Basel III implementation of risk-based capital requirements versus the more straightforward leverage ratios?

The first thing to say is that Basel III risk-based standards and the leverage ratio, which is not risk-weighted aren't mutually in conflict. Indeed, Basel III one of its great attractions, one of the new things it bought, was to introduce a leverage ratio internationally for the first time ever. That was very much a step in the right direction. Most countries are in the process of implementing those Basel III agreements, including the leverage ratio bit. That was agreed in Europe just a couple of weeks ago, it's working its way through the machine in the US. Other countries â€" Canada and elsewhere â€" are at various stages of having legislated for Basel III. So this is happening. But at the same time, there is an ongoing debate â€" everywhere, actually, and particularly evident over the last 6-9 months â€" about whether the risk-weighting scheme that currently underpins the Basel III risk-based capital standards is quite fit for purpose. In particular, whether it might be subject to gaming, whether some of the risk weights might be a bit flaky, whether banks with identical exposures might actually end up actually holding rather different amounts of capital. Those concerns have grown over the last 6-9 months and there's been a quest to perhaps simplify and make more comparable the existing risk-based capital standards. There's a working group in the Basel committee thinking about this. The G20 heads of state committed us to thinking about this, about a month ago. So the pendulum is swinging â€" it's swinging in a simplicity direction. And leverage ratios as a simpler metric of bank solvency might be part of the solution to that complexity problem. There's more distance to travel but my sense is the pendulum swing is beginning

02.49 Q: So it's misguided to see the leverage ratio as a crude tool that penalizes basic low-risk products?

One thing to say, is that there isn't a capital adequacy metric on the planet that is immune to arbitrage, to people fiddling. That isn't immune to some imperfection of some type or other. I'm not saying that the leverage ratio is perfect by any means, and no solvency metric for a bank can be. One of the real attractions it has, I think, is that it's simple to understand. So if you're an investor in a bank looking in at lest with a leverage ratio you know what you're getting, you know what's inside in a way that cant possibly be the case with a risk-based regulatory ratio. Because it's based on models which are opaque. It's based on millions and millions of observation and risk-weights, which are unobservable. So with the best will in the world, those measures lack transparency. That's one thing a simple leverage ratio can give you.

Another it gives you, it seems, is a better degree of predictability about which banks are at risk of failing. So if you think back to the crisis and ask which banks failed and which banks didn't, and which measure of their solvency or capital adequacy told the better story the answer, in fact, was the simple leverage ratio, Simple did better than complex in making sense of the crisis, in separating the sheep from the goats in the banking system. So crude it may be, but sometimes it's better to be roughly right than to be precisely wrong.

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