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Your committee is also looking at the
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important issue of leverage for banks.
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It gets a little complicated, but it's
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it's it's actually critical to
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preventing the kind of crisis that we
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saw uh starting in 2008. So, the example
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cited in the pre uh press release by
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your committee uh compared tier one
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capital of 141 billion versus its equity
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of just 98 billion.
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So, it's a matter of choosing which one
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of those numbers you plug into the
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formula to judge how sound liquid, how
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much leverage this bank has. Can you
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explain that because it's really
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critical, little complicated, but very
00:00:41
worth understanding. Uh yes, it's one of
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the problems we have with the multiple
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regulatory definitions of capital. Uh
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both regulators and banks tend to use
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the definition that makes them look
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best. But in fact, if you're worried
00:00:56
about a bank's ability to absorb loss
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without being reorganized or without
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receiving assistance from taxpayers,
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you're really only interested in a
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subset of the things that regulators
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used to call capital. For example, sub
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debt won't work because um you have to
00:01:13
go through a bankruptcy proceeding
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before that becomes available. Um a lot
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of preferred debt won't work. It's
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really equity that is the primary uh
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shock absorber. So that if a bank takes
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a hit on the asset side, the equity
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holders have nothing to do but say ouch
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and you can keep the bank going. But
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that's that's your foundation. The
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equity is the foundation of the bank.
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And that in fact was the really
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important innovation in Basel 3. uh in
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Basel 3 they made a very clear
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distinction
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between capital that was able to uh
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absorb loss and permit the institution
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to keep going that is going concern
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capital and what they called gone
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concerned capital or capital you could
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only use after the institution went
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through some sort of resolution or
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bankruptcy process. Now, it turns out
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they were simply following the market
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because during the crisis, it was in
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almost every case true that whenever an
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institution failed, its regulator was
00:02:18
was caught in the really awkward
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position of having a press conference
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where they had to explain why the
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institution failed despite the fact they
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had a riskadjusted capital ratio that
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was far above the peers. Their numbers
00:02:31
looked good. The numbers looked terrific
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because they were manipulated. they
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invited manipulation. Um, one of the
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best examples of this is that City Bank
00:02:39
had, I think, one of the highest tier
00:02:42
one riskadjusted ratios of all the banks
00:02:45
at a time when its share price was
00:02:46
trading at about a dollar a share. So
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that the the clear distinction between
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what the regulators somehow thought and
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what the market believed was just
00:02:55
completely uh stark and obviously it it
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it undermined all credibility in the
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regulatory approach. So where is that
00:03:05
today? Is that it's is it being fixed?
00:03:07
Is it not being fixed? Is it is it being
00:03:09
fudged? Well, it's being fixed, but um
00:03:12
it's being taken up reluctantly. The US
00:03:15
has long had a leverage ratio. Um the
00:03:18
FDIC uh who views itself as paying the
00:03:21
bill when things go wrong has always
00:03:23
insisted on it and uh it led to a long
00:03:26
delay in the US acceptance of Basel 2.
00:03:29
Um at during the crisis however a number
00:03:33
of other countries became persuaded that
00:03:35
we were right that leverage was a much
00:03:38
better indicator of a bank's ability to
00:03:40
absorb loss than the very elaborate and
00:03:43
very um obscure riskadjusted ratios. Uh
00:03:47
and so the new version Basel 3 does
00:03:50
include a leverage ratio of 3%. They
00:03:54
have a very clear methodology of of
00:03:56
comparing uh basically uh shareholder
00:03:59
net worth to assets that are augmented
00:04:02
to reflect um offbalance sheet
00:04:05
positions. Uh that is not yet however
00:04:09
baked into the hard number test because
00:04:11
a number of Europeans had no hope of
00:04:13
meeting it. Actually the British just
00:04:15
reported it. They're the first country
00:04:16
to have reported their uh banks
00:04:18
information that way uh earlier this
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week. And of the five leading banks, um,
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one didn't make it, one that we would
00:04:27
have thought was the best and two others
00:04:29
were just at the line. We don't actually
00:04:31
know how it would play for US banks
00:04:33
because it's a little different than we,
00:04:35
uh, actually compute it. But it's by
00:04:38
using a different ratio as the Fed did
00:04:40
in its recent stress test, you can make
00:04:42
a a big difference in how banks look.
00:04:46
You can make a big difference in the
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numerator as you indicated by including
00:04:50
things other than common equity. So you
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can get to tier one by adding a lot of
00:04:54
things that are kind of like equity but
00:04:56
not really and that's why you had uh
00:04:59
those two examples Morgan Stanley and
00:05:01
city were taken because the differences
00:05:03
are very large in that case. So this is
00:05:05
the fudge factor. That's a fudge factor
00:05:06
in the numerator. But it's also possible
00:05:09
to fudge the denominator. And that's
00:05:10
even more worrisome because during the
00:05:13
first quarter, we saw a lot of
00:05:15
improvements in these ratios. But when
00:05:17
you looked behind the numbers, it was
00:05:19
because banks had so-called refined the
00:05:22
risk models, which is to say the risk
00:05:24
models had been adjusted to give them
00:05:26
lower risk weights. Um, and we've also
00:05:29
had a recent study by the Basel
00:05:30
Committee that shows that if you give
00:05:32
the same portfolio to several different
00:05:34
leading banks, you're going to end up
00:05:36
with very very different risk numbers.
00:05:40
And so, uh, these things are really not
00:05:43
reliable because they are so subject to
00:05:46
manipulation. Moreover, they make it
00:05:48
impossible for anyone on the outside to
00:05:50
compare one bank to another because you
00:05:53
have to know the details of all of its
00:05:54
models, which in some cases can be as
00:05:57
many as 200 million calculations, which
00:06:00
is just, you know, impossible. Um, and
00:06:03
so, uh, we were concerned that the Fed
00:06:05
was going to lose an opportunity, as it
00:06:07
turns out, they did, to actually use the
00:06:10
new clean leverage ratio as the hallmark
00:06:13
of the strength of US banks in reporting
00:06:15
the results of the simulation tests. So,
00:06:17
on the road to making the global
00:06:19
financial system more safe and to
00:06:21
preventing the kind of meltdown that we
00:06:23
had five or six years ago, um, we
00:06:26
haven't gotten very far. uh not nearly
00:06:29
as far as we should be, but um at least
00:06:32
putting leverage into the regulatory mix
00:06:34
was an improvement. Uh now if they would
00:06:37
fortify it and uh actually use it more
00:06:41
frequently as a reporting and comparison
00:06:44
device, I think uh we would have made an
00:06:46
advance. Thanks very much for joining
00:06:48
us. Thank you.
00:06:53
[Music]
