Fed Weighs Tighter Cap On Bank Leverage

Source: Federal Reserve | Flickr

Federal Reserve officials are weighing a stricter cap on bank leverage, a move that would respond to increasing demands to constrain the riskiness of large lenders.

According to people familiar with the matter, Fed officials have discussed increasing the amount of equity capital banks are required to hold, setting the bar higher than the 3 percent of assets level agreed internationally.

The move is being considered amid growing skepticism about the Basel III capital accords, which impose higher capital requirements on banks around the world but allow them to vary the amount depending on the riskiness of individual assets. Officials are concerned that some banks are gaming the system.

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However, critics of a higher leverage ratio argue that it is a blunt tool that makes no distinction between safe securities, such as U.S. Treasurys, and risky assets such as leveraged loans, and could result in banks taking on more risk.

In Congress, a proposal to impose a 15 percent leverage ratio on the largest banks has secured bipartisan support. Analysts calculate it would require the likes of JPMorgan Chase and Bank of America to forego dividends for years to retain a total of $1.2 trillion of equity.

Few regulators want to go so far, with many believing it would harm the financial sector and curb lending. Any increase would also reduce profitability.

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But some senior Fed officials believe a higher ratio could be justified as a backstop to the risk-based Basel requirements.

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Tom Hoenig, vice-chairman of the Federal Deposit Insurance Corporation, has said 10 percent would be a "reasonable" leverage ratio. A policy group, whose members include Paul Volcker, former Fed chairman, and Sheila Bair, the previous head of the FDIC, has urged the Fed to set a leverage ratio of 8 percent.

In the UK, Andy Haldane, executive director for financial stability at the Bank of England, has advocated a leverage ratio of 4-7 percent.

A majority of officials at both the FDIC board and the Office of the Comptroller of the Currency, another bank regulator, are also in favor of going further, according to people familiar with discussions.

Jeremy Stein, Fed governor, said this month that if present capital rules turn out not to deliver "much of a change in the size and complexity of the largest of banks", then perhaps the requirements "should be ratcheted up".

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The talks come as Republicans and Democrats call for big banks to be forcibly restructured or meet much higher capital requirements.

Jeb Hensarling, House financial services committee chairman, said he favored simpler rules governing capital, as opposed to the current risk-weighting scheme which benefits larger banking groups with significant trading operations that rely on internal models.

"Balance sheets are going to have to become far less opaque in order to reinstate market discipline," he said.