“Simpler Regulation Is Not Better Regulation”

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Aug 23, 2013
by Louise Hallman
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“Simpler Regulation Is Not Better Regulation”

Finance session Fellows debate the benefits of a simple leverage ratio versus a risk weighted assets regime  Fellows debate the case for a simple leverage ratio over risk weighted assets

Taking shelter from an unusually chilly August night, 53 central and commercial bankers, regulators, supervisors, academics, politicians and other financial experts gathered in the Great Hall of Schloss Leopoldskron to consider whether “simpler regulation is better regulation”.

Chaired by Douglas Flint, Group Chairman of HSBC Bank Plc in London, the two teams* debated either in favor of the current system of risk weighted assets, which seems to lead to remarkably different results from bank to bank, or in favor of the simple leverage ratio, which many view as too simple. Whilst perhaps not as immediately accessible to the non-financial expert as last year’s debate “The surest solution to ‘too big to fail’ is to break up the banks” (indeed it’s not the sort of topic that would be discussed over cornflakes with your children, as one participant joked), the matter under discussion was nonetheless important.

As one Fellow put it: “How would you explain leverage ratio to your children? It’s quite simple: I would take them to a children’s playground and take them to the see-saw; and then I would place the kids on one end, and with some speed I would jump on the other end. And I would then I would see my future capital evaporating into thin air! That would be an indication that I should see my medical supervisor to have a discussion about whether my weight is too risky. But even to the untrained eye it’s obvious that too high a leverage is pretty risky and you should therefore place a limit on the leverage ratio you take.”

After hearing the two teams’ for and opposing arguments, the debate was opened to the floor and eventually a vote was taken. Below are some of the quotes presented in the main cases in favor of the simple leverage ratio and risk weighted assets system.

*Please note that as the debate was held under Chatham House Rules, no names of team members or audience speakers will be published. All participants were speaking in a personal capacity and do not represent the views of their respective organizations.

In favor of: Simple Leverage Ratio
“Do you want something simple that leaves bankers to do their job? ...Or do you want the regulators to intervene on a daily basis?”

“The methodology behind risk weighted assets underestimates rare events…[which means] it does not work in times of crisis, but we are still using it to work out how banks should work in times of crisis! ...All traders know that when there is a crisis, when there is a crash, you just turn off your computer…you know it doesn’t work on days when 25 standard deviation events happen ten times a day—which statistically is absolutely impossible, but in the real world does happen. So how can we compute the amount of capital that banks need with methodology that simply does not work?”

“Risk weights have been a way for bankers and politicians to fiddle with the figures… Who has decided that all lending to all SMEs in Europe would bear a risk of 75%? What’s the science behind this? Aren’t we just using risk weights to lull ourselves into a false sense of security?”

“Risk something that is dynamic, it’s not something you carve in stone and say ‘Oh, I know the risk is this.’" 

“If we’re saying that less regulation would lead to riskier behavior, are we saying that banks just can’t be trusted with money?”

“To paraphrase Donald Rumsfeld, we need to know our unknowns as well as the unknown unknowns; risk weights only measure the known unknowns.”

“We need legislation that doesn’t require wheelbarrow to move it around!”

“If a simple leverage ratio makes a good ‘back stop’ for banks, why not use it as the ‘front stop’?”

“Leverage ratio is not going to be there naked! It’s still going to have a large exposure regime. There will still be requirements for diversity. There would still be requirements for liquidity. And so it’s just a question of if you’re going to have a leverage ratio anyway, it’s relatively accurate, it doesn’t have quite so much in it that’s bogus, Basel have already done the corrections to deal with the difference in the accounting standards. We should get rid of something [risk weighted assets] that we don’t need, that really doesn’t do us any good, and makes legislation far too complex. We want simplification because that’s the only way to actually get understanding [both from politicians and the public].”

In favor of: Risk Weighted Assets
“Why is a simple leverage ratio a bad idea? Historically there is not a lot of evidence it worked. The 19th century was not a happy time – there were credit and stability crises time and again.”

“Squeeze the balloon in one place and it’ll come out somewhere else – we’re driving banking into the shadows.”

“A mandatory simple leverage ratio penalizes banks with large assets.”

“A simple leverage ratio could force banks out of high volume-low return banking, raising the price of credit.”

“Banking is a complicated business… Leverage ratio is pursuing simplicity at the price of ignoring the risk. We’re oversimplifying a complex thing!”

“Only having a simple leverage ratio is like flying only knowing the wind speed, without knowing the height or the tilt of the plane.”

“Banks are in the business of managing risk, particularly credit markets, liquidity, and transformation risks. And to manage those banks and to supervise those banks, it’s absolutely essential to use risk-based models. To move away from risk-based models would be mad!”

“Leverage ratio doesn’t distinguish between good assets or bad assets – an asset is an asset… It’s really important to appreciate that a leverage ratio would lead banks to maintain the minimum liquid asset buffer and have no incentive to have any surplus above that minimum. Do we really want banks to be doing that in relation to one of their most important risks?”

“If you’re a bank where the leverage ratio is the key constraint and not the risk weighted asset ratio, it means all the effort, all the focus on risk weighted assets, all that understanding of risk is ignored, and we run the risk of creating lazy supervision because supervisors will focus on the leverage ratio – they don’t need to worry about risk weighted assets either – and we end up with the worst of all worlds where there’s a misalignment between the way in which banks look at and manage risk, and the way in which regulators are looking at them.”

“If you take away the sophisticated and granular understanding of risk, those discussions [between banks and supervisors, and between different supervisors] lose any grounding in substance.”

“Investors need to be able to understand the risk in banks and one of the things investors want is much more detail and granular understanding of the risks in the portfolios of banks. Risk weighted assets: not perfect, but provide a key input into that really important information flow to that key stakeholder group.”

“Humankind makes progress going forward – leverage ratio is a step backwards.”

Result
For a simple leverage ratio: 17 votes 
For risk weighted assets: 19 votes

It would appear this group of Salzburg Global Fellows doesn't quite agree simpler is better.