Hoenig hits out April 11, 2013 at 6:50 am

This man really knows how to make a speech. The following is from one he gave in Basel (!):

An inherent problem with a risk-weighted capital standard is that the weights reflect past events, are static, and mostly ignore the market’s collective daily judgment about the relative risk of assets. It also introduces the element of political and special interests into the process, which affects the assignment of risk weights to the different asset classes. The result is often to artificially favor one group of assets over another, thereby redirecting investments and encouraging over-investment in the favored assets. The effect of this managed process is to increase leverage, raise the overall risk profile of these institutions, and increase the vulnerability of individual companies, the industry, and the economy… If the Basel risk-weight schemes are incorrect, which they often have been, this too could inhibit loan growth, as it encourages investments in other more favorably, but incorrectly, weighted assets. Basel systematically encourages investments in sectors pre-assigned lower weights — for example, mortgages, sovereign debt, and derivatives — and discourages loans to assets assigned higher weights — commercial and industrial loans. We may have inadvertently created a system that discourages the very loan growth we seek, and instead turned our financial system into one that rewards itself more than it supports economic activity.

Clearly there is some truth to this. I don’t buy Hoenig’s argument (via Admati and Hellwig) that the cost of moving to a high simple leverage ratio is small: it isn’t. But it may still be worth it.

5 Responses to “Hoenig hits out”

  1. Let me posit a different answer for a leverage ratio (note that I am a convert and had long been against one).

    Banks and other financiers, by their inherent interest, should price for varying degrees of risk. This means pricing for expected loss, and a charge on the capital they need to hold for unexpected loss. It is in their inherent self-interest to do so.

    But financiers may be wrong in their estimates of the risk. If they over-estimate the risk, society shouldn’t care (other than efficiency arguments). However, if they under-estimate the risk, they will hold less capital than they need, and if they are “large and systemic” to the point that resolution could involve asset liquidation that pushes other firms into distress, we should care.

    As the GFC demonstrated, certain credits can only go one way – Aaa credits (and really Aa credits pretty much as well). A portfolio of highly-rated positions will be highly leveraged, and the “surprises” are skewed towards the downside.

    This argues that we should SUPERVISE firms to make sure that they are internally charging for risk, but should REGULATE a simple leverage ratio as a control against mis-rating credits.

  2. One interesting angle in the speech is the allocation of resources in the economy that risk weights drive. Fast forward to the brave new world of macroprudential regulation and in the UK the BoE will be picking sectoral risk weights. The modern day equivalent of industrial policy?

    In my humble opinion that seems nuts. And is why I look forward to seeing the political debates unleashed when the central bank seeks to over ride politicians’ preferences and tighten risk weights in favoured sectors.

    One more thought. How many smart people cld be released to do something else other than building risk weight models if we moved to a leverage ratio alone? Suspect it’s a lot.

  3. I wholeheartedly buy all the criticisms of the Basel RWA approach. The banking sector is increasingly looking like some sort of repeated game of socialist-like central planning and “gotcha” regulatory workarounds.

    But the simple leverage ratio approach seems extremely trivial to bypass. Maybe I’m missing some aspect of it, that a proponent could illuminate me on. But say you have a regulated institution, Bank A. Let’s say Bank A if unconstrained would fund itself in a certain way and invest in certain assets, such that it’s leverage ratio would be 25:1.

    But say the regulators cap the leverage ratio at 10:1. So a second bank, Bank B, is created. Bank B buys all the assets that Bank A wants to buy in the unconstrained scenario, and funds itself such that it’s leverage ratio is 5:1. Then Bank A buys up all the equity of Bank B and funds itself so that it’s leverage ratio is 5:1.

    You now have the economic result as the unconstrained case. Bank A is holding the same assets as it was before, at an effectively 25:1 leverage ratio. The only difference is the presence of a pass-through bank that steps down the leverage ratio for regulatory purposes.

  4. Carter –

    You said “This argues that we should SUPERVISE firms to make sure that they are internally charging for risk, but should REGULATE a simple leverage ratio as a control against mis-rating credits.” I absolutely buy that argument, thank you.

    QM – There are I think two great arguments for moving to a simple leverage ratio: one is yours, about freeing up smart people to do better things. The other is that they would be easily checkable, and hence investors would have some confidence that they knew what a leverage ratio meant and that it was correct (modulo accounting shenanigans of course).

    Doug – Material holdings in a financial institution are a deduction from capital so your play doesn’t work but I fully accept that some funkier version of it might. In some sense it always has – think ABCP conduits. I’m still positive though that the larger abuses can be controlled.

  5. Hoenig is correct, in my opinion. The Basel Rules assign a very low weight to “riskless” assets, which several years ago included AAA rated mortgage backed securities. We all know what happened then. Bankers are paid to game the system; they piled into these AAA securities, leveraged up, and went broke.
    The current noise about Deutsche Bank’s leverage in its US subsidiary is a similar case of exploiting the rules to make money. A simple high leverage ratio may not be possible, but the current system is asking for trouble.