Speaking at the Exchequer Club of Washington D.C., FDIC Vice Chair Thomas Hoenig outlined the possible benefits of strengthening leverage capital requirements for derivatives. He also compared two primary approaches for setting regulatory capital requirements: (i) leverage and (ii) risk-based standards. Vice Chair Hoenig criticized efforts to weaken the leverage ratio’s treatment of derivatives, and declared that the alternative risk-based capital framework option has proved to be “entirely unsuccessful.”
In response to the argument “by some regulators” that the leverage ratio is a threat to the clearing of derivatives, Vice Chair Hoenig asserted that:
- The leverage ratio sets capital requirements “in a simple way” by requiring that capital exceed a percentage of balance sheet assets;
- The potential cost increase of hedging exposures from requiring capital for derivatives trades “reasonably reflects the reduction of a subsidy that resulted from artificially low capital”; and
- The leverage ratio includes guarantees, whether for derivatives or other obligations, to ensure that banks “do not move significant sources of exposure off-balance sheet.”
Vice Chair Hoenig said that the new approach, which “scraps” the current “look-up table” used by the leverage ratio to measure the potential future exposure of derivatives, will become effective in 2017. According to Vice Chair Hoenig, this new approach will (i) be more risk-sensitive, (ii) provide incentives for clearing and margining and (iii) greatly reduce overall risk-based capital charge for derivatives. Striking a cautionary note, he added that extending this new measure of exposure for calculations affecting leverage ratio would be “grossly at variance with the goals of a simple, non-risk sensitive constraint on financial leverage” due to its erasure of large amounts of “meaningful” economic exposure to derivatives with a measured exposure of zero.
Vice Chair Hoenig concluded by saying that “the leverage ratio – because it is a relatively straightforward check on excessive debt financing and, yes, because it has teeth – has always been a lightning rod in the debate and always will be. If regulators can stay the course on this important measure, our financial system will be stronger and more resilient going forward.”
Lofchie Comment: The fact that the leverage ratio is simple does not mean that it is clever. Simple solutions share one attribute with complex solutions: both can be completely wrong. As Vice Chair Hoenig concedes, it is not only market participants who believe the leverage ratio (as proposed) to be impractical; many of his fellow regulators believe that, too. At some point, the argument that because there was a financial crisis, Rule X is good stops being persuasive (although it never should have been). The burden must be on the government to make clear why a particular rule makes sense and how it will change the behavior of individual participants and the market as a whole in a positive manner.
In a certain sense, arguing that higher capital requirements will reduce risk is a bit like saying that lower taxes will stimulate business and raise revenues. It may be true, but only to a degree. It cannot possibly be true in extreme cases. At a certain point, raising capital requirements without considering actual risk not only damages the economy, but also makes the markets more fragile, since market participants will find hedging too expensive.