CRM Policy Group & Leverage Ratios

The Counterparty Risk Management Policy Group has released its August 6, 2008 Report. I have not read it in full, but it does have some things to say about the “leverage ratio” – known, roughly, in Canada as the Assets-to-Capital Multiple:

The Policy Group is strongly of the view that leverage ratios are a seriously flawed
measure of capital adequacy, except in highly unusual circumstances. The limitations that are inherent to leverage ratios were spelled out in the CRMPG I Report in 1999 and repeated in the CRMPG II Report in 2005.

As set out in detail in Appendix A of the CRMPG I Report, traditional measures of leverage, such as total on-balance sheet assets to equity, are misleading because they inadequately capture the relationship between the real risk of loss and the capital available to absorb it. A gross on-balance sheet leverage measure (1) does not take into account the potential variability in the value of off-balance sheet assets, (2) does not capture the risk dynamics of assets with embedded leverage, (3) does not give credit for hedging (including when matched book assets are perfectly hedged with offsetting liabilities), and (4) most importantly, fails to distinguish between assets with the same balance sheet value but widely differing risk. All balance sheet measures of leverage share a critical flaw in that a firm that appears to have relatively low leverage can nonetheless be taking substantial risks, while a firm that looks relatively highly leveraged may well be taking little risk. Viewed in isolation without greater understanding of the risk characteristics of portfolio assets, balance sheet measures of leverage can send false signals about a firm’s financial and risk condition. Appendix A to the CRMPG I Report explored these flaws and offered progressively more sophisticated measures of leverage to address them. In the end, CRMPG I concluded there is no single right measure of leverage. The challenge for financial institutions is to ensure that there is deep understanding and management of how asset liquidity and funding liquidity interact dynamically for a given portfolio of assets and sources of financing, including capital.

Notwithstanding the Policy Group’s view as to the shortcomings of leverage ratios, the Policy Group does recognize that (1) in some circumstances they can provide useful information and (2) in the aftermath of the credit market crisis they cannot be dismissed out of hand.

IV-21a. The Policy Group recommends that where the use of leverage ratios is compulsory, supervisors monitor such leverage ratios using the Basel II, Pillar II techniques and intervene regarding the adequacy of such leverage ratios only on a case-by-case basis.

IV-21b. The Policy Group recommends that efforts be directed at either (1) framing more meaningful leverage ratios where they exist or (2) phasing out their use and implementing alternative risk measures that more effectively fulfill their intended objectives.

The Policy Group is too ashamed of its 1999 Report to make it available on its website, but it’s available from the US Government

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