The challenges of the leverage ratio

Published on February 29, 2016   11 min

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0:00
I'm Simon Samuels. I'm a Banking Consultant having spent the last quarter of the century analyzing the European banking industry from an equity investor's perspective. And I'm going to talk about the challenges of the leverage ratio.
0:16
Most major banking systems are essentially shaped by the regulatory framework in which they operate. And one of the features of the banking system before the onset of the financial crisis was that the banking system, particularly in Europe, was huge. Banks in countries like Iceland, Ireland, Switzerland, and the UK, with four, five, six, seven, seven, eight times the size of the underlying economies in which they operated. Whereas by contrast, banking systems in the United States and other countries were dramatically smaller. One of the biggest drivers of that difference is the regulatory framework. Put very simply, banks, typically in Europe, didn't really care about their total assets. They were very much focused on their, so called, risk-weighted assets, that is their assets adjusted for the different perceived levels of risk. That was what the regulators, their managements, their shareholders were primarily focused about. And so the fact that the European banks have enormous balance sheets essentially was of little concern. By contrast, the regulatory framework of banks in the United States was one that was primarily about the overall size of the balance sheet, the total assets. So U.S. banks essentially cared about their balance sheets, total assets, and didn't really care about the risk-weighted asset equivalents, whereas the banking system in Europe was essentially the opposite. And one of the consequences of this is that the financial architecture in these two countries grew up very, very differently.
1:43
So for example, the European banks love mortgage lending because mortgage lending might generate high total assets but on a risk-weighted asset equivalent the number is very, very low. And so in Europe, almost 9 out of 10 mortgages are provided by European banks. Whereas by contrast, in the United States, the mortgage asset is essentially an asset that's not very much liked or enjoyed by the banks themselves. Because it's very capital intensive from a leverage perspective and the fact that it enjoys a very low risk-weighting is of essentially no consequence. So the U.S. banking system didn't primarily look at the risk-weighted asset calculation. So in Europe, the mortgage markets are dominated by banks. In the U.S., the mortgage markets is at least almost half of it coming from Freddie Mac, Fannie Mae and other government sponsored entities. And exactly the same story in the corporate lending markets. High quality corporate lending is a very attractive product for European banks because on a risk-weighted basis, the risk weighting is very low, whereas by contrast, high quality corporate lending is not very attractive to U.S. banks because the low risk weighting has very little impact, because their regulation framework is primarily around leverage. So in the U.S., over 7 out of 10 corporate loans come direct from the bond markets and only a tiny fraction come from the U.S. banking system directly.
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The challenges of the leverage ratio

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