Slightly scary stories about the leverage of European banks

by on May 20, 2010 at 7:21 am in Current Affairs, Economics, Law | Permalink

Felix Salmon and I were on the radio a few days ago and we agreed (I think) on the need for as-simple-as-possible stronger limits on bank leverage.  I browsed the web to see how this struggle was going and ran across the following, from March:

A planned cap on bank leverage would not make the sector safer, said a German banking lobby on Friday, adding heavyweight support to a growing campaign.

This is scary for at least two reasons.  First, it may be difficult to implement a leverage restriction in the United States, as supposedly this would be happening through an international agreement, namely Basel III.  This is a major (the major?) problem with the current banking bill.  There is then this:

France does not want a fixed numerical cap, preferring to give national regulators discretion in supervising leverage.

Deutsche Bank (DBKGn.DE), a member of the BDB, says a ratio is simplistic, while Sweden wants a carve-out for its banks.

And this:

The BDB said a study from the WHU Otto Beisheim School of Management concluded a ratio would likely force banks to scale back on lending and threaten recovery.

Might I go out on a limb and suggest that some of these European banks are…excessively leveraged?  In theory the Basel III reforms will adjust the leverage restrictions for the risk of bank assets.  It's been the case for a long time that many German banks have higher measured degrees of leverage.  But are they more leveraged, all things considered?  If they're worried about Basel III, maybe the answer is yes.  

Roger Koppl May 20, 2010 at 7:30 am

Janet Yellen has called for discretionary regulation, which is built into the Dodd and Frank bills. We are probably moving to an international regime of discretionary regulation, which favors big players and hampers competition. The public choice angle here is obvious.

David May 20, 2010 at 8:21 am

Here is why Europeans don’t want leverage ratios-> IFRS deals with gross exposures compared to net exposures under GAAP. Banks like DB have high reported leverage ratios compared with US banks, but that difference would disappear or significantly narrow if the same accounting standard were used.

Here is a graphical illustration->

Doc Merlin May 20, 2010 at 8:28 am

1. Certain types of assets can (and very likely will continue to) be leveraged out the wazoo legally.
2. This will increase the market for regulatory arbitrage.

Norman Pfyster May 20, 2010 at 9:14 am

One of the great economic lessons I learned from Steve Landsburg was if you posit some certain level of something is good, you must argue why THAT level is good. Here, if you are positing that less leverage is better, you seem to be driven to abolishing fractional-reserve banking, too.

All of this assumes that leverage was the problem and not cash flow. In other words, how does less leverage address “shadow banking” runs?

Fleg May 20, 2010 at 9:34 am

@Roger Koppl : Discretionary regulation is just Europe-deared fair competition –with taxpayers money : the most expensive world sports event for eggheads.

Larry Glenn May 20, 2010 at 11:45 am

The crux of the problem is not leverage, per se. What is done with leverage is the matter of concern. If leveraged contracts are contractually marked to market and margin posted and maintained, there is no problem because when a default occurs the contract is closed and settled. That may be painful for one or both of the parties to the contract but society does not suffer. The problem is that governments, banks, and others are using leverage without the discipline of sound accounting and margin maintenance. Nothing good will come of such idiocy.

Hrm May 20, 2010 at 6:47 pm

Are there any historical examples of countries that didn’t allow debt/lending/leverage at all? It’d be interesting to know exactly what sort of a society that would look like.

Eric Rasmusen May 21, 2010 at 4:20 pm

Saying that the regulators should have discretion rather than require a fixed capitalization ratio for banks could be either because the regulator wants to be more cautious than that (good) or less cautious (bad). The problem for the US and Europe both was, I think, using fixed ratios (maybe not required by regulation or statute in the US, but it looks as if that’s what the regulator did in practice). Then, in the US the regulators said AAA meant “safe” when any sensible person knew it didn’t anymore, and in Europe the regulators still say “EU sovereign debt” means “safe”. Maybe VAR sophistry is allowed to mean “safe” too.

The scariest thing is that in Europe they’re saying that those same banks whose capital– not whose wild speculations, but whose “capital”— includes Greek debt are overcapitalized and fixed rules would require too much conservatism.

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