Forget Tarp and its mutant offspring. The long-term shape of global finance will be shaped by future levels of bank leverage. But what is the right amount? Regulatory frameworks, such as Basel II, have steered banks towards having a minimum amount of equity-type capital versus assets. The assets are then given risk weightings: more equity backing here, a little less required there.
But even when playing within the rules, the most conservative banks still became ridiculously geared. Under the most basic version of Basel II, triple-A corporate bonds have a 25 per cent risk weighting. That means banks can theoretically ramp up their exposure to this asset class by 50 fold and still not breach the required capital ratio of 8 per cent. Government bonds, with a no risk weighting at all, can be leveraged to the stars.
To illustrate the insanity of such gearing, analysis by Banca del Ceresio shows that most hedge funds look like church pension plans in comparison with banks. Applying Basel II risk weightings to the assets of a standard directional portfolio suggests that hedge funds typically operate with more than 3 times the minimum regulatory capital requirement for banks. And whereas leverage at banks can easily reach north of 30 times, supposedly risk-loving directional hedge funds with no capital adeqacy requirements manage similar assets to banks with only about 4 times gearing.
Of course, relative value hedge funds (such as arb funds) are more geared. Still, the fact that even the least geared banks have been bailed out during this crisis proves that bank leverage is far too high. But reducing the total leverage in the banking system by at least a half – not an unreasonable start – would probably guarantee a worldwide depression. That leaves injecting capital, but the private sector is nowhere near big enough to stump up what in some countries could be up to 10 per cent of output. Historic banking crises often resulted in wholesale nationalisations. This one could too.
But even when playing within the rules, the most conservative banks still became ridiculously geared. Under the most basic version of Basel II, triple-A corporate bonds have a 25 per cent risk weighting. That means banks can theoretically ramp up their exposure to this asset class by 50 fold and still not breach the required capital ratio of 8 per cent. Government bonds, with a no risk weighting at all, can be leveraged to the stars.
To illustrate the insanity of such gearing, analysis by Banca del Ceresio shows that most hedge funds look like church pension plans in comparison with banks. Applying Basel II risk weightings to the assets of a standard directional portfolio suggests that hedge funds typically operate with more than 3 times the minimum regulatory capital requirement for banks. And whereas leverage at banks can easily reach north of 30 times, supposedly risk-loving directional hedge funds with no capital adeqacy requirements manage similar assets to banks with only about 4 times gearing.
Of course, relative value hedge funds (such as arb funds) are more geared. Still, the fact that even the least geared banks have been bailed out during this crisis proves that bank leverage is far too high. But reducing the total leverage in the banking system by at least a half – not an unreasonable start – would probably guarantee a worldwide depression. That leaves injecting capital, but the private sector is nowhere near big enough to stump up what in some countries could be up to 10 per cent of output. Historic banking crises often resulted in wholesale nationalisations. This one could too.
