leverage

In June last year, the Bank of New Zealand issued the country’s first covered bond – securities backed, for example, by mortgage payments. (So the bank, receiving loan payments, in turn issues debt, receiving cash for that and allowing them to lend more.) Seven months later, the central bank has already seen fit to limit issuance of these bonds to 10 per cent of a bank’s total assets.

The practice allows a bank to increase leverage. The popularity of this and similar leveraging techniques in the US and Europe has been blamed for difficulties faced during the credit crisis. Complex interdependencies are created by reselling debt, repackaging it or simply issuing new debt on the basis of cashflow from other debt. 

New research suggests – perhaps unintentionally – that leverage ratios are a poor indicator of impending severe bank stress or failure, casting doubt on the heavy reliance placed upon them in stress tests and efforts to make the banking system safe.

As part of a broader study, a BIS working group looked at data on 117 banks, and tried to find levels of key leverage ratios that could be used to separate the ultimate fortunes of the bank. For example, did banks with a Tier One ratio below 4 per cent always fail? Did banks with Tier One ratios above 10 per cent always succeed?

The short answer is that these levels were not very instructive. One level the paper suggests is 4 per cent for the Tier One ratio. But the actual finding is that in 50 per cent of cases, banks with more than 4 per cent did not go on to suffer severe stress, and banks with less than 4 per cent, did. Fifty per cent is rather low, however: could one similarly ‘identify’ the fate of banks by tossing a coin?

The paper says that there is no “correct” method to identifying these levels, though it seems that this should have called for a classic regression analysis. 

Lots of central bank news: the Bank of England extends QE by £25bn in what is seen as a “gradual decline” of the programme, and there are rumours that the ECB could begin exiting part of its stimulus as early as December. The Fed statement yesterday was largely unchanged.