PrefBlog

My interest was piqued by a paper by R. Alton Gilbert, a former VP of the St. Louis Fed; the paper was an advocacy piece, Keep the leverage ratio for large banks to limit the competitive effects of implementing Basel II capital requirements.

The abstract reads:

In October 2005, the agencies that supervise U.S. depository institutions proposed changes in the Basel I capital requirements that will apply to the banks that will not be subject to the new Basel II capital requirements. An objective of the U.S. bank supervisors for proposing changes in Basel I capital requirements is to mitigate any competitive inequalities created by implementing Basel II capital requirements. This paper explains why the proposed changes in Basel I capital requirements would not mitigate such competitive inequalities for many of the banks that will continue to be subject to the Basel I capital requirements. In addition, this paper argues that an important means of limiting competitive effects from implementing Basel II capital requirements is to maintain the leverage ratio as one of the capital requirements for the banks that adopt Basel II capital requirements.

… with the thesis:

This paper argues that the proposed changes in Basel I capital requirements would not mitigate the competitive effects of implementing Basel II for many of the banks that will continue to be subject to Basel I capital requirements. For various reasons some of these banks are not bound by the minimum capital requirements of Basel I, in the sense that they would not reduce their capital if the supervisors reduced the minimum capital requirements. Other banks are bound by the leverage ratio, rather than the risk-based capital requirements of Basel I. The leverage ratio is a minimum ratio of Tier 1 capital to a measure of total assets.

… and:

One way to mitigate competitive inequalities under Basel II is to maintain the leverage ratio for the large banks that will be subject to Basel II. The leverage ratio places a tight limit on the percentage by which the largest U.S. banking organizations would be permitted to increase their assets (for given capital) under Basel II. Chairman Powell of the Federal Deposit Insurance Corporation recently argued for retaining the leverage ratio for the banks that adopt Basel II. He argued for retaining the leverage ratio on the basis of the degree of risk assumed by the individual banking institutions that will adopt Basel II capital requirement. This paper adds another reason for retaining the leverage ratio for the banks that adopt Basel II. The changes in Basel I capital requirements the at the supervisors proposed in October 2005 will not affect the capital held by many of the banks that will continue to be subject to Basel I capital requirements. For these banks retaining the leverage ratio for the banks that adopt Basel II is a means of mitigating competitive inequalities created by implementing Basel II.

He supports the views of Powell – former FDIC Chairman – but for different reasons. Powell’s views were referenced in PrefBlog in the post Expected Losses and the Assets to Capital Multiple.

So, after reading through his paper, I wondered: what is the constraint on the balance sheets of Canadian Banks. I drew some data from the second quarter summary of Canadian banking capitalization and drilled down back into the supplementary packages reported by the banks to produce:

It should be noted that the percentage increases calculated imply no change in asset mix, which will not be accurate. It may be assumed, for instance, that in the event of credit lines being drawn down, or an unexpected burst of lending activity, other assets will be liquidated to fund them, rather than having them funded by new liabilities. Royal Bank, for instance, reports that as of April 30, securities held that were guaranteed by Canada or a province totalled $27.1-billion. This amount is very close to its total capitalization. Deposits with other regulated financial institutions (other than the Bank of Canada) totalled $15.8-billion. While some of these assets will be held in the ordinary course of business – trading operations and whatnot – a large chunk of these assets could be sold to fund new business expected to be more profitable than government securities. This would increase Risk Weighted Assets without affecting the ACM.

Still – given that Royal Bank is over the 20x ACM limit and had to apply for special permission to achieve this state, it looks to me that the major constraint is the Assets-to-Capital multiple; which is consistent with Powell’s and Gilbert’s assertions with respect to the US. It is not consistent, however, with an assertion by OSFI that “the leverage multiple is not usually the binding constraint for large complex banking organizations”.

I will have to investigate this further!

This entry was posted on Tuesday, June 24th, 2008 at 2:00 pm and is filed under Interesting External Papers, Regulatory Capital. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.