Leverage ratios are "counterproductive", says IIF

In a new report on how to strengthen financial regulation, the Institute of International Finance (IIF) has proposed some measures directly at odds with options currently being explored by regulators in both Europe and the US.

The Restoring confidence, creating resilience report was unveiled yesterday in New York and represents the "global industry perspective" informed by the insights and experience of the IIF's 375-member financial institutions.

Although the proposals are ostensibly in line with regulatory proposals proposed by both the G-20, the Financial Stability Board and other financial policymakers, in some instances the IIF's recommendations run counter to steps advocated by national and supranational regulators.

The IIF, for example, opposes the levying of leverage ratios to create a minimum capital floor, stating that "a simple leverage ratio runs the risk of undermining its own objectives. Any measure to contain leverage should take account of the differences in business models and funding structures."

"We agree that there was too much leverage in the system before the crisis but hardwired leverage ratios may not take account of the portfolio composition and basic risk issues and we're concerned it may be counterproductive," said Bill Winters, co-chief executive officer of JP Morgan's investment bank and a member of the IIF board of directors.

European regulators are currently exploring the possibility of imposing a leverage ratio on financial institutions within the European Union for the first time. Additionally, Stefan Walter, secretary-general of the Basel Committeeon Banking Supervision, told Risk last month the financial crisis may have validated the need for leverage ratios.

"I don't think it is necessarily correct to say the existence of a banking crisis in a country that had a leverage ratio invalidates the measure. Some might argue the leverage ratio may have actually helped to avoid an even worse scenario than that which has unfolded so far," Walter said.

Another area of divergence in the report emerged over the issue of identifying banks of such size and complexity that they present a systemic risk to financial markets.

Regulatory reform plans announced by the Obama administration in the US in June would identify systemically important institutions as "tier-one financial holding company" (FHC) institutions, which would be subject to special oversight and additional capital requirements. The Federal Reserve is slated to take on a systemic risk regulator role in supervising tier-one FHC firms, if the regulations are signed into law.

Despite these measures, Walter Kielholz, chairman of the board of directors at Swiss Reinsurance and a member of the IIF board of directors, warned against the dangerous precedent such action would set. In the event of another crisis, he argued, counterparties would flock to transact with the largest firms obliged to adhere to the most draconian capital and risk management requirements, putting smaller firms at risk.

"We are convinced it would be absolutely counterproductive to create a formal category of highly systemically relevant firms that should be subject to separate or additional regulations, and by consequence create another category of firms that are not systemically relevant. Large and complex financial institutions need to be subject to more intensive supervision because they have larger organisational footprints and deeper balance sheets, but it is not prudent to establish a specific category," Kielholz said.

Attempts to standardise over-the-counter (OTC) derivatives in order to facilitate clearing of trades with a central counterparty - as championed by US Treasury secretary Timothy Geithner - was also cautioned against.

"A move to fully standardised products would come at the cost of much less-effective risk hedging. Clients would be prevented from utilisng hedge accounting techniques, resulting in increased earnings volatility and potentially increased risk. Striking the right balance is crucial," the report read.

Generally, the 22 commitments and 44 recommendations in the report were largely in line with previous reports from bodies such as the FSB and the Counterparty Risk Management Policy Group, calling for the establishment of supervisor colleges, an international solvency standard for the insurance industry and the establishment of a mechanism for the failure of large institutions that spares wider market participants adverse shockwaves the fallout.

"For markets to operate effectively there needs to be market discipline, solid regulation and sound supervision. Firms of any size and shape need to be able to fail without disrupting the market. That means that investors and creditors need to face the possibility of losses. It needs to be realistically feasible for even the largest financial firm to fail," said Winters.

A copy of the report can be found at: http://www.iif.com/press/press+76.php

See also: Obama reforms silent on OTC derivatives clearing
Building up Basel II
The bank capital burden