Big Banks Can Do More With Less Leverage

Race to the top, anyone? U.S. bank regulators on Tuesday shrugged off concerns about creating an uneven playing field and approved a new rule imposing tighter strictures on big firms’ use of borrowed money.

These will likely exceed what will take effect elsewhere, notably in Europe. But this doesn’t have to be a liability for U.S. banks. Higher levels of capital allow banks to better withstand shocks. So while leverage constraints may damp returns on equity, they reduce the risk borne by shareholders and creditors. That can actually be positive for both share and debt prices.

In Europe, by contrast, high levels of leverage are one reason investors continue to doubt bank strength.

True, safety has a cost. Regulators estimate the eight largest U.S. banks combined will require around $22 billion in additional capital to meet the new, 5% leverage threshold at the bank-holding-company level. At banking subsidiaries, subject to a 6% hurdle, big banks will need a further $38 billion.

The tab may be higher thanks to a proposal that would count off-balance-sheet credit derivatives in measuring bank assets. That could hit hard at J.P. Morgan Chase, JPM +0.14% the biggest large-bank holder of these instruments.

Regulators estimate this change would require an additional $46 billion, bringing the capital shortfall to $68 billion across the eight big firms. At the bank subsidiaries, it would require an additional $57 billion—bringing the total to around $95 billion.

Meanwhile, commendably, regulators resisted calls to exempt cash held at central banks from the leverage-ratio calculation. While this argument had some merit, a chief virtue of a leverage rule is that it doesn’t depend on judgments about the risks of different assets. Even a well-intentioned exemption could have been a first step on a very slippery slope.

Come the next period of financial turmoil, investors aren’t likely to cry over the fact that U.S. banks have stronger balance sheets than competitors around the globe.

via HEARD ON THE STREET: Big Banks Can Do More With Less Leverage – Article by John Carney

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