Barclays is complaining. The Prudential Regulation Authority (PRA) is proposing to test the bank's ability to comply with a proposed new regulatory target - the leverage ratio.
In corporate finance, the leverage ratio is the ratio of equity to total debt. But in the banking world, the leverage ratio is the ratio of equity to total assets. It is in theory a simple measure, although different accounting standards do make a difference to its calculation - for example, US GAAP and IFRS netting rules for derivative exposures are different, which leads Simon Johnson to make the mistake of claiming that Deutsche Bank's leverage ratio is too low relative to US banks, when actually under US GAAP it is rather good....However, I digress. The capital ratio, by contrast, is the ratio of equity to risk weighted assets. Risk weighting reduces the value of a particular asset or asset class in the capital ratio denominator: unsecured risky loans are weighted at 100% (i.e. the denominator includes the full value of the loan), but other loans are weighted at various percentages depending on the creditworthiness of the borrower, the value of any collateral and various other risk measures. Obviously, the lower the risk weighting, the lower the amount of capital needed to meet the capital ratio target set by regulators.
Barclays knew it couldn't meet the new leverage ratio target of 3% before 2015. So the bank's CEO, Antony Jenkins, warned that if the bank had to meet that target early, it might have to cut lending to UK households and businesses. This was dynamite. As the Sunday Times says (paywall), the PRA is incensed. A lovely spat is brewing between Jenkins and the PRA's head, Andrew Bailey, who has made it clear that cutting lending to the UK economy is unacceptable. But Barclays is by no means the only bank that is complaining about the new leverage ratio.
The biggest complaints have come from building societies and other lenders who specialise in mortgages. They argue that the leverage ratio penalises them because it fails to take into account the "lower risk" of mortgage lending. Nationwide, the UK's biggest building society and fifth largest lender, says it will have to find at least an additional £1bn of capital, which won't be easy because as a mutual it can't easily tap the financial markets for new equity.
Frankly I am amazed that anyone can seriously suggest that mortgage lending is "lower risk". Charles Goodhart recently commented that there have been four UK banking crises in his lifetime, of which three were caused by property market collapses. When house prices fall - which in the UK they do about every 20 years - even supposedly safe mortgages become risky, and risky ones become toxic. And commercial property is even more vulnerable. Collapsing commercial property values was one of the biggest causes of UK bank insolvency in the financial crisis, and several of the UK banks still have significant amounts of impaired commercial property loans sitting on their balance sheets.
The idea that mortgage lending is "lower risk" comes from the fact that it is secured on property. Mortgages don't usually cover the entire cost of the property at the time of purchase. What is known as the "loan-to-value" (LTV) ratio is the ratio of the amount of the loan to the value of the property, and in a good quality mortgage it will be not more than 80%. The remainder is covered by the borrower from own funds and/or unsecured borrowings, often from family and friends. In financespeak, the property is the "collateral" against the loan, and the difference between the amount of the loan and the value of the property is the "haircut". In the event of the borrower defaulting on the loan, the bank can seize the property and sell it to recover the loan amount. Therefore the risk that the bank will lose money on the mortgage is regarded as low.
As I explained above, capital adequacy rules take into account lending risk. In the case of good quality mortgages, risk of default is negligible because of the value of the collateral. I should make it clear that collateral is not bank "capital" - it is the borrower's capital. The bank doesn't own the property, the borrower does, even though the borrower has bought it with the bank's money. But because the loan is secured on the borrower's capital, the bank doesn't need much capital of its own to support it. That's the traditional view and the justification for low risk weighting of mortgages in regulatory capital rules.
But mortgage risk rises spectacularly when there are housing bubbles - as there have been in the run-up to EVERY property price collapse in the last 50 years, not just 2007-8. Encouraged by the prospect of high returns and blinded by rising property prices, banks water down their lending standards. They lend larger proportions of the value of the property, even lending over 100%*. And they lend to poorer credit risks - people with no steady income, people who already have high debts, the recently self-employed, people who don't want to disclose anything about their financial circumstances. Capital adequacy rules do adjust to take account of increased credit risk, but in a rising property market this is still offset by the value of the property. Basically, as long as property prices are expected to rise, the view remains that the bank can't lose and therefore doesn't need much capital of its own to support even risky mortgages. In the run-up to the 2007-8 financial crisis, many banks' and building societies' capital margins were paper-thin.
When property prices fall, the "haircuts" on real estate collateral shrink. Obviously, for good quality mortgages this is annoying but not disastrous: a 75% LTV might rise to 90% but it isn't going to be wiped out. But for higher-risk mortgages, the effect on the bank's balance sheet can be terrible. If property values fall by 11%, all mortgages with LTVs of 90% or more are underwater (the loan amount is more than the value of the property). If a proportion of these borrowers then default on their loans, the bank takes losses. If the bank's own capital is insufficient to absorb those losses, then its creditors are at risk and it is insolvent. This is why apparently sound banks can suddenly become insolvent when asset prices are falling. I've shown this here with mortgages, but the same applies to other forms of lending and purchased securities, including the infamous CDOs whose value crashed to almost zero in the financial crisis.
What I describe above - property market collapse leading to widespread bank insolvency - has happened three times in the last 50 years in the UK: in 2007-8, 1990-92 and 1973-5. And it has now happened in the US for the first time in 70 years, with a much bigger correction than the UK experienced. Each time it was preceded by bubble lending and increasing risk in mortgage books. Each time, banks failed and were bailed out - in the first two crises (especially the 1973 crash) they were bailed out by the central bank, and in the most recent crisis they were bailed out by the Government. And each time, bank capital calculated using risk weighting rules failed to ensure that banks had enough capital to withstand losses on mortgages - including commercial property and construction loans.
This is why, in my view, the leverage ratio is essential. Risk weightings are not an adequate measure of risk when asset prices are falling, so reliance on risk weighted capital ratios can result in banks having insufficient capital to support losses. And furthermore, I think it is essential that capital rules are NOT watered down for supposedly "safe" specialist mortgage lenders. There is nothing "safe" about a specialist lender that is lending 95-125% LTV to poor credit risks - as Britannia Building Society and Northern Rock were both doing. Specialist lenders should have to comply with an unweighted leverage ratio just as universal banks will have to.
There is still a role for risk weighted measures, however. The problem with a leverage ratio is that it can encourage high-risk lending. After all, returns are better when risks are higher, and if regulatory capital rules ignore risks, banks might as well go for the really high-risk, high-return stuff. This can make their balance sheets more unstable and increase the risk that they will actually fail, which is not really what we want. So in my view we need both risk weighted capital ratio and leverage ratio. They do different jobs.
And there is one other matter too. Bank lending is fundamentally pro-cyclical: higher returns and (apparently) lower risks encourage excessive lending when times are good, but when times are bad low returns and high risks (especially if asset prices are or have been falling) discourage lending. Therefore macro-prudential regulation needs to be counter-cyclical. There has been some discussion of adjusting capital requirements according to the business cycle - relaxing capital adequacy rules in downturns to encourage lending, and tightening them in booms to discourage excessive lending. This is a start. But it is not enough. Lending standards are always watered down in the run-up to a crisis. Macroprudential regulation should be looking at asset quality, not just at capital levels.
And we also need to reconsider the effect of interest rate policy in booms and recessions. Standard macroeconomic interest rate policy cuts rates in recessions and raises them in booms. This affects demand for lending, because borrowers don't want to borrow at high rates but are often happy to borrow at low rates. But the converse is true for banks. Low interest rates discourage lending: high interest rates encourage lending. There is clearly a conflict of interest here which means that relying on interest rates alone to control bank lending is doomed to fail. I don't have a simple answer to this problem, but we need to look at ways of influencing bank behaviour that don't involve clobbering their margins when they are already damaged, or encouraging them to lend far too much at far too high a risk when times are good. And that involves building macroeconomic policy models that include banks as active participants rather than passive intermediaries, so that the effect of bank behaviour can be factored into forecast effects of macroeconomic policy. Unless we do that, we are going to continue to get macroeconomic policy horribly wrong, encouraging banks to behave badly and cause intermittent crises at terrible cost to our economy. As we have done persistently over the last 50 years.
Bank lashes Barclays for loans threat - Sunday Times (paywall)
Risk insight: The Weakness in US GAAP Netting Assumptions - Nicholas Dunbar (Bloomberg Brief) (h/t Dan Davies)
British Banks' Comedy of Terrors - Simon Johnson (ProSyn)
Deutsche Bank's capital raising highlights leverage ratio bite - Euromoney
* High LTV mortgages are certainly not a recent phenomenon. My first mortgage in 1988 was 100% LTV. The property market crashed less than two years later and I was "underwater" (in negative equity, as we say in the UK) for the next five years.