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ABA Chief Economist Chessen: Risk-based capital system better than leverage ratio

James Chessen

James Chessen

James Chessen, the chief economist at the American Bankers Association, recently said a risk-based capital system established by regulators is a better way to measure and protect against bank-related risks than the leverage ratio advocated by some lawmakers.

Chessen said leverage ratios by themselves cannot identify a troubled financial institution, American Banker reports.

“To abandon the risk-based approach and rely instead on pre-1930s Depression-era ratios as some in Congress have suggested is to ignore the tremendous progress that has been made to make the financial system safer for depositors,” Chessen said, according to American Banker. “It also takes us further from customized bank supervision, an approach that regulators have recently recognized is important to preserving the banking industry’s diversity.”

In graphs provided by the FDIC and analyzed by the ABA, Chessen compared Tier 1 risk-based standards and leverage ratios over the past 10 years. Leverage ratios did not distinguish banks that have failed since 2008 from healthy institutions.

“Two similarly-sized institutions can have dramatically different risk profiles, so the leverage ratio provides little useful information on the safety and soundness of a bank,” Chessen said, American Banker reports. “This is why the risk-based ratio, for all its shortcomings, did a much better job distinguishing banks that would go on to fail from those that survived.”

Overall, going into the crisis, failed banks were more aggressive lenders and had much higher loan-to-deposit ratios than surviving banks. After the fall of the economy, losses overtook capital reserves and contributed to bank failures.

Many institutions failed because losses were so large that no capital level could have saved the banks. More than 50 percent of institutions that failed between 2008 and 2010 would have failed even if they had a capital ratio of 25 percent in 2008.

“Everyone shares the goal of having an appropriate amount of capital to protect creditors against losses,” Chessen said, according to American Banker. “Everyone shares the general belief that more capital, including high-quality capital, is appropriate given the experiences of the financial crisis – and that’s why market and regulatory pressures have already led to a significant increase in both the level of capital and its quality.”

Chessen said, however, that it is possible to have too much capital, which results in less lending as banks and other institutions shrink to meet regulatory capital-to-asset ratios.

“Risk-based capital is far from perfect, but the debate should be on how it can be meaningfully improved instead of calling for a return to the age of black-and-white TVs and no Internet,” Chessen said, American Banker reports. “We all want more simplicity, but our world is no longer simple. It’s time to find the right capital rules for the risks taken, regardless of an institution’s size.”

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