Dear,
For years, the financial system has been driven by volume; economic growth required, and still requires, feeding the monster of debt; but the monster has become too big, making the system unsustainable, that’s why we’re in a systemic crisis.
Recovering the sustainability of the system requires efficient management of scarce resources, and capital is the main and most scarce resource of the financial system.
The systemic transformation requires increasing capital requirements, making visible its importance by raising its price. In other words, making capital expensive is the best way for incentivizing its efficient management.
Solvency agreements (Basel I and Basel II) should have prevented the insolvency of the financial system but history proved that they did not. As a consequence, capital requirements were increased and a tighter regulation (Basel III) was implemented after 2008 events.
Basel III increased the capital requirements in several percentage points (3%-5.5%) and required the implementation of two new ratios; Leverage Ratio and Liquidity Ratio.
The new Leverage Ratio is not “Risk Weighted” which means that does not distinguish between risky and not risky investments. It sounds estrange when we have being said that risky investments are the main threat for the stability of the financial system.
The best explanation of the necessity of a Leverage Ratio is in the speech “The dog and the Frisbee”, by Andy Haldane; Chief Economist and Executive Director, Monetary Analysis & Statistics of the Bank of England.
Basically, Mr. Haldane is telling us that “As regulators don’t trust the complex Internal Rating and Capital Requirements calculation of the banks, they’re implementing a simpler rule for preventing over-leverage”
The proposal seems logical, if complex statistical rules of risk calculation can’t prevent over-leverage (because they can’t be verified by the auditors), let’s implement a simple rule (that can be audited). At the end, dogs don’t need to understand complex laws of physics for catching a Frisbee.
I would agree if leverage was the problem, but unfortunately it’s just a symptom. The real problem is capital scarcity and the solution requires capital optimization.
Requirements which don’t estimate capital consumption can’t incentive capital optimization, that’s why the leverage ratio will not work in the long-term.
Don’t forget that the main justification for the leverage ratio is the difficulty for auditing the bank’s models for capital requirements calculation. If auditing the bank’s internal models is difficult, transparency measures should be implemented for facilitating auditing. Unfortunately that’s much more difficult than it sounds.
Banking Information systems are built on obsolete, heterogeneous, lightly integrated databases. Determining and reporting meaningful solvency calculations in these conditions is technically impossible.
That’s why today’s alternative is a regulatory leverage ratio, if we can’t verify complex rules, let’s implement a simple one.
But as the systemic crisis evolves, the effects of capital scarcity will be more visible and painful, making necessary the implementation of capital optimization measures.
By that time, banking information systems will have to be ready to determine capital consumption properly, including the reporting capabilities for auditing the results.
Understanding the laws of physics is not necessary for catching a Frisbee, but transforming the financial system is a much more challenging endeavor.
Understanding the laws of physics is not necessary for catching a Frisbee, but transforming the financial system is a much more challenging endeavor.
Join the SAP Banking Group at: http://www.linkedin.com/e/gis/92860
Looking forward to read your opinions.
K. Regards,
Ferran.
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