August 27, 2013
Sir, Peter Sands, the chief executive of Standard Chartered comes out against a leverage ratio and in defense of the risk-based capital requirements for banks which, in its more advanced version, Basel II, has only been around us for less than a decade and already created the greatest crisis ever seen, “When it comes to banks, simplest is not always best” August 27.
Beside their simplicity I have always favored leverage ratios for two reasons. The first that it guarantees that the banks will have some capital when the risk-weights turn out to be wrong, which is in fact the only case when bankers and regulators run into deep problems.
Secondly and perhaps even more important, it does not distort the allocation of bank credit to the real economy. Current risk-weighing, which translates into banks earning much more risk adjusted returns on their equity when lending to the “absolutely safe”, than when lending to the “risky”, does only guarantee the former get too much credit at too low costs, and the latter too little at too high cost.
Banking must seem to be all for Mr. Sands, but he would do good remembering that the state of the real economy is even more important, not only for us all, but even for the safety of the banking system.
For instance Mr. Sands writes that “the leverage ratio… assumes lending to a start-up and an established multinational are equivalent risks”. Precisely! If Mr. Sand applied the correct interest rates, awarded the correct amounts of exposures, and set the correct terms of the contracts, these should be equivalent risks from the banks perspective, and which lead to undistorted and efficient credit allocation in the real economy.
To end let me quote from what Mr. Banks and the Bankers sang us about banks, in Mary Poppins.
If you invest your tuppence, wisely in the bank, safe and sound
Soon that tuppence, safely invested in the bank, will compound
And you'll achieve that sense of conquest, as your affluence expands
In the hands of the directors, who invest as propriety demands
You see, my friend. You'll be part of railways through Africa.
Dams across the Nile. Fleets of ocean greyhounds.
Majestic, self-amortizing canals. Plantations of ripening tea
All from tuppence, prudently, fruitfully, frugally invested.
Sir, let me assure you that risk-weighting will not only keep the banks away from those “prudently and fruitfully” investments in the real economy, but that there is also nothing "frugally", in leveraging 30 times to 1 or more. How sad Mr. Sands seems to look down on old British banking traditions.