Leverage in banks and derivatives
February 7, 2006
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Commenting on my
blog about an Economist column on CDOs, Ajay Shah
in his blog that the comparison between derivatives and banks is
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
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
- 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.