Monday, March 23, 2009

The shocking reality of leverage ratios

The Turner report, published by the Financial Services Authority, is proving to be a rich seam of outrageous charts. Indeed, it is ironic that the authority produced the most definitive assessment of the crisis while the industry it was supposed to supervise is teetering on the brink of collapse.

If only it had produced a similar analysis five years earlier. Perhaps it might have done something about the unconscionable behaviour of UK banks. I know - "should have; could have; would have" - it's all too late. The greatest financial crisis in a century is now upon us, and regret doesn't help much.

Nevertheless, it does no harm to the back in horror at what the banks were doing over the last 10 years. Perhaps the best guide to banking sector irresponsibility is the leverage ratio. Banks invariably prattle on about risk weighted capital adequacy ratios, but the thing that really matters is leverage - the ratio of bank assets to capital.

Regrettably, it is now all too clear that investment banks pushed their leverage ratios to insane levels. Capital is the buffer that allows banks to a absorb losses. If a bank has a leverage ratio of over 30, it will become insolvent if only 3.5 percent of its assets become unrecoverable. According to the FSA, UBS had a leverage ratio in excess of 40 over the last four years. This is the banking equivalent of playing Russian roulette.

(click on the chart for a sharper image)

As the Turner report confirms, the major investment banks had leverage ratios hovering between 20 and 30. However, the picture within the retail UK banking system is both more horrifying and more complex. UK banks have a long history of comparatively high leverage ratios. On average, that ratio has been at least 20, although it has been creeping up in recent years.

However, the average is just a measure of the midpoint. As the FSA painfully points out, some banks have ratios considerably higher than 20. In fact, according to the Bank of England, one bank had a leverage ratio in excess of 60. Moreover, the variability of leveraged ratios has been growing that some time. Some UK banks were prudent; other banks had a death wish.

Looking at these charts, there appears to be a strong element of naivete. There is something childlike about a bank that pushes up its leverage ratio when the economy is booming and it is easy to produce profits. It betrays an immature and untutored belief that the world is a calm and benign place, where nothing can go wrong and where everything will turn out just right.

It was as if banks were living like a fairy tale princess, who used a magic spell that made that that nasty dragon, known as risk, disappear. However, risk could not be wished away. It has returned like an avenging psychopath from a slasher movie.


  1. Your conclusion might be stated that banks knew that they could blackmail government support if the unthinkable happened. The banksters knew that too big to fail meant they in the end, would win either way....if things turned out ok or if they didn't. Who would not play to win when the game is rigged? Leverage ratios were the manifestation of that belief.

  2. @Boat52

    Quite so. And it would seem that they could do the same all over again, and be bailed out all over again. Brown's statement that they want borrowing to return to early 2007 levels is a clear indicator that he has no idea of how to build an economy except by borrowing.

    Anyone who shot him would be doing the nation a fine service.

  3. immature and untutored belief that the world is a calm and benign place

    clearly you are right overall, but untutored may be too strong

    there was no shortage of 'reputable' economists preaching the New Moderation which, because it was founded upon the thesis that regulators and central banks had discovered the secret of eternal low-inflation growth, offered the prospect of actually reduced macro-risk

  4. There is something childlike about a bank that pushes up its leverage ratio when the economy is booming

    Maybe not:

    What IF said bank was hedging by buying CDS on it's own debt? ANY amount of leverage would be perfectly OK then.

    What IF The Management of said bank was hedging privately by buying CDS on the banks debt debt?

    It's all OTC, who would ever find out??

  5. You write as though the banks made some kind of mistake. They didn't. Employees made huge sums of money, as simple as that.
    Criticising those much richer than yourself is meaningless.
    They won and the UK taxpayer lost.

  6. Cannot see that this outrage over "leverage" is much different from the old Douglasite protests at private banks creating credit. In which case the old remedies: Social Credit ( Douglas) and Stamp Scrip still apply,possibly.

  7. count me as a cynic, but your own graph disproves what you have the leverages for 5 banks. and your whole argument revolves around something like leverage is bad, banks were overleveraged, ergo banks are bad

    but the only one of the 5 who went bankrupt is the least leveraged and the only one who kept a fairly constant leverage for the last 10 years. Which is Citigroup (PS: Citigropu didn't go bankrupt, I know, but only because Timmy went to their rescue. ANyway, my point is that Citi is by far the one in the worst condition among the 5)

  8. continuing the above comment, congratulations for the blog!