Leverage Ratios & Interconnected Markets
Introduction (Via Vox.Eu)
Did allowing financial institutions to become “too big” play a role in the financial crisis? This column argues that being “too interconnected” is also a factor, and that US accounting standards should recognise gross derivatives exposure on the balance sheet to make this interconnectedness, and the resulting exposure, clear.
By now there is general agreement that a financial institution can not only be “too big”, but also “too interconnected” to fail. But how do we measure what it is to be too interconnected?
This is where accounting enters the picture, for it turns out that some accounting systems show important interconnections, whereas others do not. Moreover, when interconnections are revealed on balance sheets, they have an important impact on one measure of risk, the leverage ratio, which is supposed to supplement the traditional risk-weighted capital-adequacy measures under the Basel rules.
Are we primed for another crisis?
Properly measured, leverage is still at the same level as at the peak of the bubble in late 2007. The conditions for a new systemic crisis are thus still in place.
Why has the leverage ratio, defined as total assets divided by total capital, become popular? Because it directly shows the maximum percentage loss a bank can sustain on its assets before it loses all of its capital. For example, if the leverage ratio is 50, capital disappears if the bank loses on average 2% on its assets. This is why some observers have proposed adding this crudely calculated leverage ratio to the standard risk-weighted capital ratios under the Basel regime.
In practice this idea will immediately encounter a fundamental conceptual problem in the context of making transatlantic comparisons, given that the EU uses different accounting principles (International Financial Reporting Standards or IFRS) than the US, which follows the Generally Accepted Accounting Principles or GAAP.
These two accounting systems generally yield similar results, but they present a completely different picture in the case of derivatives because exposure to this particular financial instrument is reported gross under IFRS, but net under GAAP. This makes a huge difference, as illustrated by the following two examples.