The challenges of the leverage ratio

Abstract

The crisis of confidence in the risk-weighted asset (RWA)-based capital ratios has seen regulators increasingly embrace the non-risk weighted ‘leverage ratio’ for measuring capital adequacy. While such ratios have the apparent virtue of simplicity, debates over the definition of assets in practice make the leverage ratio a far from simple measure. Moreover, the initial Basel III idea of the leverage ratio being little more than a ‘back stop’ measure appears to have been overtaken by its promotion to Pillar I status, thus ranking it as the equivalent to the RWA measures. For European banks in particular — who unlike US banks have not developed the necessary financial architecture to cope with a leverage ratio — this represents a major challenge, disrupting the economics of different business activities. Rather than the current unappealing choice of following either a not-trusted internal ratings-based measure or an ultra-crude leverage measure, a better option might be standardised RWAs.