Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Goodhart’s law and leverage ratios

I am a strong believer in Goodhart’s Law which says that any measure begins to lose its usefulness when it is used as a regulatory target. The Basel Committee paper on “Calibrating regulatory minimum capital requirements and capital buffers: a top-down approach” released last week shows that this is quite true of the leverage ratio.

Table 2 on page 17 shows that if we exclude countries which had a leverage ratio requirement before the financial crisis, the leverage ratio does predict financial distress of banks. There is a large and statistically significant difference in the 2006 leverage ratios for banks that were stressed in the crisis of 2007/2008 and those that were not. However when these countries are included, the difference is smaller and is not statistically significant in most cases.

The Basle committee, which is now wedded to the idea of a leverage ratio, does not draw the conclusion that Goodhart’s Law is in operation. It refuses to even provide the only data which is truly relevant – the data for the countries which had a leverage ratio requirement pre-crisis. It is very likely that for these countries the leverage ratio would have been seen to be practically useless.

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