BREAKINGVIEWS: Bank leverage spat shows the limits of simplicity

Tue Jun 18, 2013 7:44pm IST

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(The authors are Reuters Breakingviews columnists. The opinions expressed are their own)

By Dominic Elliott and Peter Thal Larsen

LONDON/HONG KONG, June 18 (Reuters Breakingviews) - The mantra "simple is better" has intuitive appeal in bank regulation. That’s why a growing band of academics and supervisors are pushing to adopt leverage as the primary measure of bank risk. But the figure is not as straightforward as it sounds. Recent sparring between Deutsche Bank (DBKGn.DE) and a top American financial watchdog illustrates why.

The leverage ratio sounds like a simple measure: a bank’s total assets, divided by its equity. Supporters argue it is harder to manipulate than risk-weighted capital ratios, which depend on banks’ own bespoke models. They also tend to use it as evidence that banks need much more capital.

Thomas Hoenig, vice chairman of the U.S. Federal Deposit Insurance Corporation, recently said Deutsche was "horribly undercapitalised" because its capital at the end of 2012 was just 1.63 percent of total assets – equivalent to a leverage ratio of 61. Both parts of that calculation are open to debate.

Hoenig’s calculation starts with Deutsche’s total assets as measured by IFRS accounting rules. This requires banks to include gross derivatives exposures in their assets and liabilities, even if those positions cancel each other out. Under this measure, Deutsche has around 2 trillion euros in assets.

Deutsche, however, prefers U.S. accounting principles, which allow banks to count assets based on net derivatives exposures. On this basis, Deutsche’s total assets are around 1.2 trillion euros.

Measuring equity is equally tricky. Hoenig used tangible common equity, which excludes items like goodwill and deferred tax assets. His logic is that such intangible items should be excluded because they cannot absorb losses.

Deutsche not only leaves in those intangible items, but also includes gains or losses on the value of the bank’s own debt when measuring equity. This added 2.4 billion euros to its equity in the first quarter. As a result, Deutsche was able to argue that its leverage ratio at the end of March was just 21.

These differences help explain why the Basel Committee on Banking Supervision will struggle to enforce a single bank leverage measure. Under Basel's current definition – which is still being debated - Deutsche's leverage ratio at the end of March would have been between 30 and 40 times.

The argument for leverage ratios is that they’re harder to manipulate, and therefore easier for outsiders to judge. The sad reality is that even this supposedly simple measure is far from straightforward.

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CONTEXT NEWS

- Thomas Hoenig, Vice Chairman at the U.S. Federal Deposit Insurance Corporation, called Deutsche Bank "horribly undercapitalised" and said it was the worst on a list of global banks published by the regulator, according to comments reported by Reuters on June 14.

- Hoenig said Deutsche Bank’s equity was only 1.63 percent of its total assets at the end of last year. Hoenig derived the ratio by using European IFRS accounting measures for the bank's assets and by stripping out items like goodwill and deferred tax assets to arrive at a tangible equity number.

- Stefan Krause, Deutsche Bank's chief financial officer, told Reuters that on that basis the bank's ratio is now 2.1 percent. Using U.S. generally accepted accounting principles, the ratio stood at 4.5 percent, Krause said. However, he added that a leverage ratio on its own is a "misleading measure" of a bank's overall riskiness.

- FDIC spreadsheet of banks' leverage:

link.reuters.com/tub98t

- Reuters: EXCLUSIVE-Deutsche Bank "horribly undercapitalized"-US regulator ž[ID:nL2N0EQ1U3] - For previous columns by the authors, Reuters customers can click on [ELLIOTT/] and [LARSEN/]

(Editing by Rob Cox and David Evans)

((dominic.elliott@thomsonreuters.com))

((Reuters messaging: dominic.elliott.thomsonreuters.com@reuters.net)) Keywords: BREAKINGVIEWS LEVERAGE/

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