Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Leverage in banks and derivatives

Commenting on my

blog
about an Economist column on CDOs, Ajay Shah
wrote
in his blog that the comparison between derivatives and banks is
equally instructive
when looking at leverage. He points out that leverage in banking is more than
in derivatives and correctly argues that the (inverse of the) capital adequacy
ratio is not the correct measure of leverage for a like-for-like comparison
with derivatives leverage.

I completely agree with Ajay on this. I present below a few like-for-like comparisons
of varying levels of sophistication all of which point to the same reality
that banks embody high levels of risk:

  • Globally, most derivative exchange clearing houses are AAA rated while hardly any
    major bank has this coveted rating today.
  • Even the AA and A ratings that large banks enjoy today depend on implicit
    support by the lender of the last resort. S & P states quite bluntly
    “Generally speaking,
    the regulated nature of banking serves as a positive rating factor, one that helps to
    offset concerns about the extraordinary leverage and high
    liquidity risk that characterize the industry. Indeed, without the
    benefits provided by regulation, examination, and liquidity
    support, bank ratings would not be as high as they are.”
    (S & P, Government Support
    in Bank Ratings, Ratings Direct, October 2004)
  • Many large global banks have been to the brink of failure and have survived only with
    some form of support from the central bank. Only a few relatively insignificant derivatives
    clearing houses have gone broke.
  • The Basel II credit risk formula uses the 99.9% normal tail or approximately
    three standard deviations in a single factor Merton model for capital adequacy for
    corporate exposures. (Paragraph 272 of Basel
    II
    ). Under the fat tails typical of asset prices (say Student t with
    6 degrees of freedom), this actually provides only 99% risk protection and not the
    alleged 99.9% protection. Moodys and S & P default data clearly show that a 1% default
    probability is not consistent with an investment grade rating. In other words, the
    latest regulatory framework for large internationally active banks is designed to produce
    a bank with a junk bond rating if we do not take into account the implicit
    sovereign support.
  • During the days of free banking in Scotland, banks used much less leverage
    than they do today. They typically had capital in the range of 20-25%.
  • Leading non bank finance companies around the world today have much lower levels
    of leverage than banks.
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