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.

Posted at 3:38 pm IST on Tue, 7 Feb 2006         permanent link

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