There is room to spare for stronger rules to protect the global financial system from banks using excessive leverage without hurting the economy, a paper published by the Bank for International Settlements, or BIS, stated on Sunday.
The paper investigated the best possible level for the new leverage ratio capital measure and found "considerable room" to raise that level to 4% or 5%, from the 3% currently tested by regulators world-wide.
This goes "in particular for global systemically important banks, where capital requirements are likely to reduce the risk of systemic crises most," wrote Ingo Fender and Ulf Lewrick in a paper that was included in the quarterly review of the Switzerland-based institute for global banking regulation. The authors' views don’t necessarily represent those of the BIS.
The leverage ratio, a relatively simple rule that set limits for balance-sheet leverage, is likely to add protection to the financial system, as risk-based capital buffers often understate risks during financial booms, the researchers said.
The BIS and national authorities started testing the 3% minimum leverage ratio in 2013 and banks have started publishing their ratios this year.
Its world-wide introduction is making more waves in Europe than in the U.S., where banks already used a similar rule before the 2008 crisis, while European banks were judged only on risk-based capital. As a result, many of the largest European banks used more leverage to juice returns from low-yielding assets.
To figure out the right proportion of the leverage ratio requirements versus the risk-based capital demands the researchers looked at risk-density: the level of risk-weighted assets a bank has per unit of total assets. For Europeans, this risk-density measure is 31% versus 50% in the U.S.
Applying their equation to historical data, the BIS scholars found that the current risk-based capital standard of 8.5% for large banks historically matches up to a leverage ratio of 4% to 5%, for the period 1995 to 2012 for a group of over 100 banks in 14 developed countries.
Weighing costs and benefits, the paper acknowledged that raising the level from 3% to 5% would prompt banks to raise the cost of loans to make up for lower returns. This would hurt investments, but the scholars argue that cost to economic growth would be very limited.
On the plus side, the researchers found that increasing the minimum level for the leverage ratio from 3% to 5% for the banks in the data set decreases the likelihood of distress for a bank from about 2% to 1.4%, making the banking system more robust. This result echoes a similar study recently published by the European Central Bank.
The potential benefit for the economy of avoiding a world-wide systemic crisis is hard to fathom, but enormous. The effects of such a crisis can linger for years and could easily cost the world a whole year of economic output, according to the BIS researchers.
Several countries in Europe with large financial institutions such as the U.K., the Netherlands and Switzerland, have already decided to raise the bar to 4% or even 5% for their largest banks, front-running the level to be decided by international regulators by 2017.
European bankers have criticized regulators' increasing focus on the leverage ratio, which doesn’t consider the riskiness of banks' assets and exposures and is likely to hurt profitability for shareholders.
"Our research indicates leverage is a poor predictor of bank failure," chief risk officer Wilfred Nagel of Dutch bank ING recently stated on his Twitter account. According to the Dutch banker, it is not asset size that drives risk, but the riskiness of assets, noting a major stress test of European banks in 2014 showed low risk-based buffers were better at predicting capital deficits than low leverage ratios.
Write to Archie van Riemsdijk at archie.vanriemsdijk@wsj.com
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