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. Read more