February 25 2016

New GBIC expert opinion: leverage ratio sets serious perverse incentives

A leverage ratio will not make the financial system more stable. On the contrary, an inflexible instrument of this kind sets dangerous perverse incentives. This is the conclusion of a new expert opinion commissioned by the member associations of the German Banking Industry Committee (GBIC) from Professor Thomas Hartmann-Wendels of the University of Cologne. As GBIC stresses, a leverage ratio prevents neither excessive leverage, nor the understating of risk, nor the procyclical effects of risk-based rules.

The expert opinion therefore clearly rejects the arguments made by supervisors, who have repeatedly called for a binding leverage ratio (ratio of tier 1 capital to total assets). The opinion comes to the conclusion that the supervisory objective of creating greater financial stability with the leverage ratio cannot be achieved. 

The introduction of this blunt indicator as a regulatory minimum requirement would lead to a reduction in the supply of credit in low-risk areas such as housing finance, development loans or lending to the public sector, GBIC warns. On top of that, borrowing costs could be expected to rise as a result of the higher cost of capital for banks.

To counter these dangers, the expert opinion recommends at least not raising further the planned minimum leverage ratio requirement of three per cent. The better solution would be to drop the idea of a minimum requirement and make the ratio a monitoring tool only (a so-called pillar II instrument).

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