The Ratio of Leverage. When you combine ignorance and leverage, you get some pretty interesting results. Warren Buffett

Transcription

1 The Ratio of Leverage When you combine ignorance and leverage, you get some pretty interesting results. Warren Buffett 1

2 What is leverage? definition of leverage: debt to equity ratio Basel Commitee: One of the underlying features of the crisis was the build up of excessive on- and off balance sheet leverage in the banking system. In many cases, banks built up excessive leverage while still showing strong risk based capital ratios. 2

3 Introduction Examples of leverage Regulatory initiatives to make banks more robust Short analysis of past regulatory initiatives Does regulation result in what it aims to achieve? 3

4 Methods to leverage balance sheets A few examples 4

5 Soft capital requirements Capital of banks consists in part of real capital, but also largely of soft capital. Real capital is equity (shares, profit reserves). Soft capital consists of perpetual or other subordinated debt obligations. 5

6 Insufficient regulation of liquidity Current regulation enables funding long term assets with short term liabilities. To date, no requirement to fund assets with debt obligations with a similar duration. In the most extreme scenario, a bank can extend long term loans (residential mortgage loans) on the basis of overnight funding (immediately repayable retail savings). 6

7 Insufficient regulation of OTC derivatives Credit default swaps are used to achieve capital relief by transferring credit risk. Credit default swaps are a common tool for achieving capital relief, but there is hardly any regulation. OTC derivatives markets are very complex. Insufficient market transparency. 7

8 Insufficient regulation of securitizations Most typical tool for banks to leverage their balance sheets is securitization. In the context of a securitization, a bank transfers assets to a special purpose vehicle, which funds itself by issuing asset backed securities. Bank receives payment from the proceeds of the issuance of securities by the SPV. Securitizations and other off-balance sheet structures have not been the subject of much regulation. 8

9 Summary Soft capital requirements, sophisticated derivative products and off-balance sheet transactions such as securitizations have enabled banks to leverage their balance sheets. Leverage created prosperity, jobs and economic growth. There is a case to be made that leverage is a good thing. But leverage also creates bubbles in economies. The leverage bubble came to a burst in 2008, resulting in an almost worldwide economic crisis. The governments and regulators of the developed world countries decided to take measures to combat leverage. 9

10 Regulatory developments 10

11 Capital requirements: Basel III Basel III will require banks to hold more real capital (equity). Less use of perpetual capital instruments and subordinated debt obligations. In addition, Basel III will introduce a leverage ratio of 3%. Bank must hold 3% equity against all on balance and off balance assets. New: both on and off balance assets are taken into account for purposes of the leverage ratio. On balance assets are taken into account on their notional value (not risk weighted). Off balance assets - such as securitized assets and OTC derivatives - are risk weighted. 11

12 Liquidity requirements Basel III will introduce duration requirements, to manage liquidity risk. Basel III requires that banks fund their assets with more stable longer term debt obligations. To date, banks were not required to fund assets with debt obligations with a similar duration. Extreme example: bank extends long term loan on the basis of overnight funding. Banks expect liquidity requirements to increase the price of longer term funding, which will cause banks to charge higher interest rates on their lending activities. 12

13 Mandatory clearing of OTC derivatives EU regulation and Dodd-Frank introduce mandatory clearing obligation for OTC derivatives. Mandatory clearing obligation applies to financial counterparties. Non-financial counterparties only if their positions exceed a specified clearing threshold. In addition, banks will be required to report their OTC derivatives transactions to trade repositories, imposing operational challenges for banks. 13

14 Case study: MiFID 14

15 MiFID: Know Your Customer Know your customer principle requires banks to assess whether an investment service is suitable for the client. MiFID requires a bank to ask its client about its investment goals, its knowledge and experience with investment products, its risk appetite and its investment horizon. Know your customer rules are rich in detail, not easy to comply with. Attention tends to focus on compliance with rules, and shift away from the underlying principle. Focus on compliance with regulatory requirements shifts attention away from the principle that a bank must know its client in order to be able to provide the best service. 15

16 MiFID: Best Execution Underlying principle of the best execution rule is that a bank must act in the interest of its clients. The client s interests should prevail when executing orders on behalf of the client. Effect of the rule was a focus on compliance with the best execution rule and detailed best execution policies. Best execution rule has not resulted in what it aimed to achieve: that banks increase their awareness of the interests of clients. 16

17 The effect of regulation? Will the Basel III capital requirements and maximum leverage ratio cause banks and economies to deleverage? Liquidity duration requirements a new standard for liquidity management? Will mandatory clearing obligation give rise to new structures to by-pass the mandatory clearing obligation? 17

18 Does regulation achieve its goals? Basel III leverage ratio favors aggressive banks over conservative banks. Leverage ratio does not differentiate between low-risk assets and high yield assets. Banks with a prudent risk management policy are at a disadvantage. It is argued that the Basel III leverage ratio will encourage investments in risky high yield assets. Rules have the potential to push aside principles, at least to a certain degree. Is it a good thing if rules that are aimed at combating leverage are not effective? Do economies need a certain degree of leverage to generate economic growth? 18

19 Questions? 19