On Leverage Ratios, Watch the Dates

In my world the big story is the approval of new supplementary leverage rules for the nation’s eight largest banks. The 5% leverage ratio (6% for the subsidiaries covered by federal depository insurance, where the mega-banks have parked most of their riskiest activities to take advantage elf the safety net) is unencumbered by the accounting tricks around “risk-weighting” that make most capital requirements, certainly the ones defined in the international Basel accords, a joke. By contrast, the Fed and its regulatory partners made it pretty simple: for every $100 in assets, you must have $5 in equity, whether retained earnings or whatever other liquid holdings, that can absorb losses in the event of crisis. The rule uses a daily average of total assets for a particular month or quarter, so banks could not ramp up their balance sheets and then sell off at the end of the period to change the ratio. The eight banks — Bank of America, Bank of New York Mellon, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, State Street, and Wells Fargo — will have to raise around $68 billion in additional capital, in response. 

That’s not enough; Admati and Hellwig suggested 25-30%, and the Brown-Vitter proposal goes to 15%. But the proposal sets a precedent, that large financial institutions present more risk to the system and therefore must have an additional capital buffer to control that risk. That precedent can be trotted out again and again, as John Cassidy notes. Once you pop, you can’t stop, so to speak. For instance, the Fed is already talking about higher capital rules for banks that rely on short-term borrowing in the wholesale funding markets.

The key drivers of this rule — Daniel Tarullo at the Fed, Jeremiah Norton and Thomas Hoenig at the FDIC, and others — should be commended for rejecting Wall Street pressure and getting this enacted, reflecting a real shift in the consensus opinion on regulating Wall Street. When Yves Smith is praising a regulatory action, you know something unusual has occurred. And there’s bipartisan support here; witness Jim Pethokoukis telling banks to stop their whining about the rules.

And yet… I can’t help but point out this feature, from the NYT write-up:

The banks and the shareholders have had time to brace for the rule, which was originally proposed in July. It is also scheduled to take effect at the start of 2018, giving the banks considerable time to adapt and raise capital.

This gives the banks almost four whole years to poke and prod the rules and whittle them down. While it’s typical to allow a little ramp time, this seems excessive even if it doesn’t get pushed out further. Even with a $30 billion deficit, as JPMorgan has according to NYT, they would merely need to retain an extra $7.5 billion or so per year to hit the rule, a fraction of their profits (or they could shrink their balance sheet, sell new equity, move things off the books, etc). For the other seven banks it would be far less onerous. And banks could push to alter the specifics of the rule in the intervening four year in ways that would reduce their capital needs. It’s like a baseball game that never ends, only moving into the next inning.

More critically, there’s ample historical precedent for whatever regulatory deadline to get stretched and stretched some more, including one from the same day that the leverage ratio was announced:

The U.S. Federal Reserve will give banks two more years to divest collateralized loan obligations (CLOs) that fall under the Volcker rule, a part of the Dodd-Frank financial law that bans banks from making a range of risky investments.

The Fed said banks will now have until July 21, 2017 to shed these funds, which pool together risky loans.

This comes just as the SEC has been investigating the explosion in CLO trading.

You add two more years for compliance with the leverage ratio, and suddenly it doesn’t look so attractive. Before reformers celebrate, they should be mindful of the fact that, just because regulators write a rule, doesn’t mean it will actually go into effect anytime soon.