How onerous are Basel III's constraints on bank leverage?

It is generally acknowledged that high bank leverage was a key factor contributing to the severity of the Global Financial Crisis. For the UK, Bank of England data suggest that UK banks’ average simple leverage – the ratio of banks’ total assets to their shareholder equity – was 24.4 over 2006.[1]

Basel III then sought to counter high leverage by imposing a minimum required leverage ratio on regulated banks.[2] The ‘leverage ratio’ is the inverse of the leverage.

So how onerous are Basel III’s constraints on bank leverage? More precisely, what is the maximum permitted leverage under Basel III?

A clear expression of the Basel rules on this point is the following from the 2015 Prudential Regulatory Authority (PRA) Rulebook in the UK:


3.1 A firm must hold sufficient tier 1 capital to maintain, at all times, a minimum leverage ratio of 3%.[3]

3.2 For the purposes of complying with 3.1, at least 75% of the firm’s tier 1 capital must consist of common equity tier 1 capital [CET1].[4]

This minimum required leverage ratio is expressed in terms of the ratio of Tier 1 capital to the leverage exposure. Section 3.1 of the PRA Rulebook would suggest that the maximum permitted leverage is then 1/3 percent = 33.33.

Section 3.2 of the PRA Rulebook then states that at least 75 percent of the firm’s Tier 1 capital should consist of CET1 capital.

Now 25 percent of the 3 percent minimum Tier 1 leverage ratio is 0.75 percent, so the minimum required leverage ratio expressed in terms of CET1 capital = 3 percent minus 0.75 percent = 2.25 percent.

This implies that the maximum permitted CET1 leverage = 1/0.0225 = 44.44.

However, Basel III also allows banks to include a ‘sin bucket’ of non-CET1 capital items as part of their reported CET1.

So let’s distinguish between ‘reported’ CET1 (or CET1 including the sin bucket) and ‘clean’ CET1 (or CET1 purged of the sin bucket).

Under Basel III rules, the clean CET1 can be as low as 85 percent of reported CET1.[5]

Let’s also assume that bankers make maximum use of the sin bucket so the clean CET1 = 85 percent reported CET1.

This means that the Leverage Ratio using clean CET1 can be as low as 85 percent  2.25 percent = 1.9125 percent and still comply with the Basel III minimum required leverage ratio. Inverting this number gives the maximum permitted leverage using clean CET1, i.e., 1/1.9125 percent = 52.29.[6]

A loss of 2 percent of the leverage exposure would then be more than enough to wipe out a bank’s CET1 capital.

In plain English, the Basel III capital rules allow banks to maintain remarkably high leverage and still be Basel III-compliant. Indeed, the Basel capital rules would appear to allow banks to maintain considerably higher leverage than they had on the eve of the financial crisis!

I should also note some qualifications, which will serve to further loosen the impact of the Basel III maximum leverage constraint:

  1. The first is that these calculations ignore sources of hidden leverage such as accounting standards that cause capital to be over-reported or the additional leverage in off-balance sheet positions.
  2. The second is that the above calculations relate to book values, not to market values, and market-value leverage these days will typically be higher than book-value leverage.

In fact, since Basel III does not impose any restriction on market-value leverage, the maximum permitted market-value leverage under Basel III is theoretically unbounded.


End Notes

* I thank Anat Admati, Tim Bush, Gordon Kerr and Sir John Vickers for helpful discussions on the subject covered in this blog posting.

[1] Obtained from the Bank of England’s Financial Stability Report for November 2016, p. 58, where the 2006 average simple leverage ratio is reported as 4.1 percent. The simple leverage is then 1 ÷ 4.1 percent = 24.4.

[2] Critics however have argued that such requirements are onerous. These include many leading bankers (e.g., Jamie Dimon and former Deutsche Bank chairman Josef Ackermann) and even central bankers (e.g., Alan Greenspan), the American Bankers Association, and the British Bankers Association (see, e.g., the citations in A. Admati and M. Hellwig, The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About it, Princeton University Press, 2013).

[3] As an aside, it is disappointing to see that the PRA’s own rulebook explicitly endorses the ‘capital is a rainy day fund’ fallacy by stating that banks “hold” capital. Banks do not “hold” capital. To suggest that they do is to suggest that capital is an asset to a bank and it is not. Read Admati and Hellwig.

[4] Prudential Regulation Authority (2015) PRA Rulebook: CRR Firms: Leverage Ratio Instrument 2015. London: PRA, p. 5.

[5] For more on the ‘sin bucket’ see T. F. Huertas (2014) Safe to Fail: How Resolution will Revolutionise Banking, Basingstoke: Palgrave Macmillan, p. 23, or Basel Committee on Banking Supervision (June 2011) “Basel III: A global regulatory framework for more resilient banks and banking systems,” pp. 21-6 and 65. 

[6] If one took account of systemic or countercyclical buffers, however, the maximum permitted leverage would be somewhat lower, but not much.

What terrors The Guardian reveals to us, eh?

We do think it must be terribly stressful being a member of the aggrieved left these days. So may of the world's basic problems are on the way to being solved, capitalism and free markets doing that solving. As this excellent chart from Max Roser shows. Given this there must be the most terrible angst suffered as something else to complain about is searched for.

As an example of this we offer the latest from The G:

Revealed: the insidious creep of pseudo-public space in London

Pseudo-public space – squares and parks that seem public but are actually owned by corporations – has quietly spread across cities worldwide.

If there were some epidemic of private economic actors taking over the publicly owned green spaces of our cities then we too might start to get a little uppity. This is not what they are complaining about.

The current publicly owned spaces are remaining as just that, publicly owned spaces. However, developers of varied private sector projects are realising that we humans like a bit of space around, a colonnade to house the cafe tables perhaps, a fountain or two, stretch of green grass to sooth the eye, this sort of stuff, possibly even just some cobbley bit to wander around in. Shrug, OK, this is the private sector, it ends up through trial and error in offering what people actually want.

These bits of open space, meeting places and all that, are additional to the publicly provided and extant ones.

At which point The Guardian is complaining. No, really, this is an outrage! The rich bastards who own so much of the world's most expensive real estate are allowing just anyone, you, me, the hoi polloi, to use that vast wealth pretty much as we wish. For free!

How! Very! Dare! They!

Clearly the law must be changed immediately to prevent anything so outrageously liberal from happening. Really, where would we all be if people were able to just decide to allow others to walk upon their hallowed flagstones?

Alternatively we might suggest a more adult reaction. A cooling glass of something frothing and a reflection, as Dr. Roser is pointing out, that we've sweated most of the difficult stuff and that the good old days are in fact now. At which point it's not actually necessary to find something to be aggrieved about.


Don't cry fowl play

Global Britain. A nimble independent Britain, freed from the regulatory shackles of the EU, was supposed to be able to rapidly sign trade deals where European efforts have stalled endlessly. And we can, but trade deals require concessions. If we want a quick and profitable deal with the USA, we need to put chlorine-washed chicken on the table.

The EU’s attempt at a better trade deal with the US has gone through 15 rounds. But post-Brexit Britain will have more latitude to make, and gain, concessions. One such concession is dropping our prohibition on chlorine-washing broiler chickens, which has frequently proved a stumbling block in EU-US deals since its 1997 introduction.

I have a piece in the Telegraph, albeit behind a paywall, explaining the findings of our new paper, written by Pete Spence, on chlorinated chicken washing and trade deals with the US. Read the whole thing, and check out the author's own case in City A.M.

Look how well we're dealing with the problem

Evidence that a problem is being solved is not evidence that we need to find a solution to that problem:

The number of homeless children living in temporary accommodation has soared by almost 40 per cent in the past three years, new figures reveal, compounding fears Britain is facing a “catastrophic” housing crisis.

Councils are housing 120,540 children with their families in temporary shelter, an increase of 32,650 extra children since 2014.

Labour’s shadow housing minister John Healey said ministers should "hang their heads in shame" over the "shocking" figures.

1210,540 children are at risk of sleeping rough. Precisely zero children are sleeping rough. That's rather good evidence that we've got a pretty good solution to the risk of children sleeping rough.

Do note that we don't therefore think that everything's just hunky dory with British housing. We've been insisting for some years now that we can make the system massively better by blowing up the Town and Country Planning Act 1947 and successors.

Evidence that millions of children are learning to read and write is not evidence of some literacy crisis. As with temporary accommodation, it's evidence that we're solving that problem.

The difference between taste discrimination and rational discrimination is an important one

That difference being that taste discrimination is doing something because of some prejudice or belief which is not rational, rational being doing that same thing for sensible reasons. The NBA is overwhelmingly black but not because those who hire the players desire higher melanin contents, but because that's just how it works when you select for the ability and desire to play basketball at the highest levels. 

Baseball provides us with another example, as that most definitely was subject to taste discrimination years back. One major reason it ended being that it wasn't rational - teams realised they were potentially losing games, series, because they were not tapping into that talent in the Negro League.

As Gary Becker famously pointed out taste discrimination is costly to those who do it and a free market is one of the best ways of getting rid of it. One of his examples being the Jim Crow laws, they existed because of this very market process. They had to be encoded into the law otherwise the market would indeed compete the discrimination away.

At which point the story about the security tags on ackee:

An angry shopper has accused Sainsbury's of racism after he found £3.80 tins of Jamaican fruit security tagged in a south London store. 

Toby Taylor, 31, said he bet the chain 'wouldn't tag hummus' and slammed it as 'corporate racism'. 

He was shopping in his local supermarket in Penge, Bromley this afternoon when he noticed a whole shelf of the delicacy had been placed in security boxes - despite being reduced and only worth £3.80. 

Supermarkets have excellent information on what walks out the door, that's what all the barcodes, scanning and computer equipment is all about. They also know, as a result, what walks out the door having been paid for and what leaves rather more lightly. Those security boxes are put onto things which tend to leave without paying tribute. They are costly, therefore it is only done to those products where it is worthwhile.

That ackee is more likely to be stolen than lychees  could be a horrible example of all things in our society. But it's not racism on the part of the supermarket. 

This BBC gender pay row makes them all appear more than a touch dim

We're watching this row at the BBC over the gender pay gap with more than just a touch of amusement. For the correct, in our minds, lesson to take from this is that most of those complaining are more than just a little dim.

Please note that we're not saying that the pay structure itself is correct, nor that that of society itself is. Those are value judgments and we'll not impose ours on you nor the real world. But the shock and horror being expressed is most odd, for the gaps being presented are little different from those across society. Indeed, the BBC seems to be doing its job of being as society, reflecting society, rather well:

Women working at the BBC have spoken of the anger and frustration that has emerged across all levels of the institution after the disparity in pay between the male and female top earners was revealed.

What is the gender pay gap does depend rather upon how one measures it. But the figure that varied feminists often use is the mean gap, uncorrected for anything like age or qualifications. They have also been told (Harriet Harman specifically in fact) not to use this as it is highly misleading.

Why so? Because if you have a distribution where the bottom anchor is zero but there is no obvious upper limit then the mean will over state the reality, the median is a better figure to use. So says that Statistics Authority.

But why is that mean misleading about the gender pay gap? Because in near all pay distributions there are many fewer women in that upper stratosphere than there are men. Yes, we do know why, motherhood, primary child carers, career breaks and so on, just do mean that the average experience of womens' working life leads to less grasping of that brass ring of a very high income. Again ,we do not say this should be so but we do insist that it is so.

It is also well known that this is so. There just always are fewer women in the upper reaches of any pay distribution, we know this so well that we've official warnings not to use misleading statistics about it all. 

At which point the amusement. The BBC is that institution which is supposed to explain this complex and difficult world to us all. Yet here we have all this shock and horror over something that is indeed known, just not by those doing the shock and horror.

Hmm, perhaps dim isn't le mot juste, ignorant of what they speak perhaps?

Good to see someone getting the point of Brexit

It's not that we approve, heaven forfend, of this particular policy idea but we do insist that this is the point behind Brexit

All of which is significant. Corbyn and McDonnell are smart enough to understand the risks of Brexit, but they also see it as an opportunity to push through their own economic agenda. Which is why they are exploring the freedom Brexit would provide for public ownership, lower rates of VAT to help those on the lowest incomes, state aid to support sunrise industries, and fair trade agreements with developing countries.

Remainers on the left would argue that there is no need to leave the EU for this to happen, but they are wrong about that for two reasons. The first is that a radical socialist programme that included a different approach to state aid, state ownership, public procurement and managed trade would be deemed illegal under European law. The second is that without Brexit, the impetus for change would quickly dissipate.

No, we really don't think that a more socialist economy is the way Britain should be moving - but you knew that, right? The underlying idea is entirely correct though. Membership of the European Union cuts us off from the possibility of a number of useful and interesting economic policies. 

We would like to see, for example, unilateral free trade. That's not something which EU membership allows. Not with that great big wide world out there that is. This is a policy different in kind from that socialism above of course - it has actually been tried and it worked, unlike socialism anywhen anywhere. We ourselves did it in 1846, that free trade thing, and we prospered mightily as a result.

Brexit allows us policy freedom which EU membership doesn't. Yes, that includes damn fool things like socialism but we are indeed all adults aren't we, capable of making up our own minds rather than having to rely upon Brussels to do it for us?

We fear Sir Michael Marmot is confused here but it's a good plan anyway

Sir Michael Marmot is famed as the academic who told us all that health inequality is caused by economic inequality. we don't doubt that this is partially true although we'd really like to insist that health inequality will produce economic as well. Becoming bedridden and incapable to work at age 40 will lead to income inequality at age 60.

His latest work tells us that life expectancy is rising more slowly in the aftermath of the recession. This could of course be true. We might even agree with Owen Jones here:

An ideologically driven programme of cuts is almost certainly robbing us of life. Consistently rising life expectancy should be something we all take for granted. The UK, after all, is one of the wealthiest societies that has ever existed in human history. There are continuing dramatic improvements in medicine and technology. And yet new research by an ex-government adviser, Sir Michael Marmot, suggests that the rise in life expectancy – a constant trend for a hundred years – has stalled since 2010. What happened that year, exactly? Was that not when David Cameron, George Osborne and their Lib Dem stooges began slashing public services with a false economic pretext?

And thus the call for revolution:

Is there any clearer evidence of how utterly bankrupt our social order is? Human and social progress is grinding to a halt in Britain. Life is getting more insecure and poorer for millions – soon, it may even be getting shorter. That’s why we don’t just need a change in government in Britain, we need a change in how we organise our society. A peaceful, democratic revolution is long overdue in Britain, for the sake of our living standards, our health – and for the sake of our very lives.

Well, OK. So, what exactly should the revolution consist of? As Marmot points to:

There is no reason why the UK could not emulate Hong Kong, where life expectancy for men is 81.1 years for men and 87.3 for women – the highest in the world – Marmot added. Hong Kong has overtaken Japan in terms of how long citizens can expect to live.

So, let's increase economic inequality up to Hong Kong levels then, cut social spending down to Hong Kong levels and slash government overall to Hong Kong levels. We're just fine with that but we do think that Professor Marmot, given his usual proclivities, is confused here. And no one at all is surprised that Young Owen is confused at all, are they?

Fake news in The Guardian

Oh dear, how embarrassing. The Guardian’s George Monbiot appears to have fallen hook, line and sinker for Nancy Maclean’s poorly (dishonestly?) researched book Democracy in Chains.

Democracy in Chains smears Nobel Laureate James Buchanan (amongst others) with deliberate misquotes and pernicious accusations of racism. It asserts that Buchanan sat at the centre of an elaborate academic conspiracy to undermine democracy and replace it with ‘a totalitarian capitalism’.

Of course, this isn’t the first time Monbiot’s been taken in by a BS Vendor who happens to share his political biases – he frequently cites Naomi Klein’s sloppy Shock Doctrine which proposed a similar right-wing academic conspiracy with Milton Friedman at the centre (thoroughly debunked by Johan Norberg at Cato).

Unlike Maclean herself, it’s not clear if Monbiot actually understands what public choice theory (the field where Buchanan made his name) is.

He writes:

James Buchanan brought these influences together to create what he called public choice theory. He argued that a society could not be considered free unless every citizen has the right to veto its decisions. What he meant by this was that no one should be taxed against their will. But the rich were being exploited by people who use their votes to demand money that others have earned, through involuntary taxes to support public spending and welfare. Allowing workers to form trade unions and imposing graduated income taxes were forms of “differential or discriminatory legislation” against the owners of capital.

Not quite.

Public choice theory isn't a set of political conclusions, it's a method of study pioneered by centre-left academics Kenneth Arrow and Anthony Downs who applied the tools of economics (e.g. rational choice theory) to the problem of political science. Buchanan describes it as “politics without the romance”. Essentially, it is a theory that predicts politics will be closer to Yes Minister than The West Wing. Indeed, Anthony Jay created Yes Minister to popularise the ideas of public choice theory.

Supporters of free and open markets tend to be drawn to Buchanan’s work in particular as it helps to answer questions like:

· Why do industrial strategies always end up subsidising losers rather than backing winners?

· Why is one bureaucrat at the Department of Agriculture for every three farms in the USA?

· Why do NIMBYs have so much power?

There are legitimate criticisms of Buchanan’s approach to public choice theory. It isn’t (or at least shouldn’t be) a theory of everything. As Ben Southwood points out, voters don’t vote solely out of self interest, they vote for the policies that they think will be best for society as a whole.

But Nancy Maclean doesn’t make those criticisms. She resorts to sloppy misquotes to paint James Buchanan as a supporter of racial segregation. An accusation repeated by Monbiot here:

He explained how attempts to desegregate schooling in the American south could be frustrated by setting up a network of state-sponsored private schools.

An explosive claim, but untrue. David Bernstein in the Washington Post writes

Meanwhile, in Chapter 3, MacLean claims that contemporary libertarians “eschewing overt racial appeals, but not at all concerned with the impact on black citizens, framed the South’s fight as resistance to federal coercion in a noble quest to preserve states’ right and economic liberty. Nothing energized this backwater movement like Brown.” MacLean identifies only two such libertarians, Frank Chodorov and Robert LeFevre. I can’t check her citation to LeFevre, because it’s from private correspondence that I don’t have access to. But her citation to Chodorov fails to support her assertion.

The article she cites by Chodorov can be found here. In it, Chodorov praises Brown: “The ultimate validation of the Court decision, which undoubtedly ranks among the most important in American history, lies in the fact that it is in line with what is deepest and strongest and most generous in our historical tradition.” Chodorov goes on to point out that merely prohibiting segregated schools won’t lead to integration because of residential segregation, and concludes that hostility to integration may lead some southern states to open up publicly-funded education to competitive private schools, which would mean “what began as an attempt to evade an unavoidable change in an obsolete system of racial segregation might turn into an interesting educational experiment.

This wasn’t Maclean’s only ‘mistake’. David Henderson at EconLib highlighted a particularly egregious misquote.

Maclean writes

'People who failed to foresee and save money for their future needs', Buchanan wrote in 2005, ‘are to be treated as subordinate members of the species, akin to . . . animals who are dependent.’

Contrast that with what Buchanan actually wrote

The classical liberal is necessarily vulnerable to the charge that he lacks compassion in behavior toward fellow human beings - a quality that may describe the conservative position, along with others that involve paternalism on any grounds. George W. Bush's "compassionate conservatism" can be articulated and defended as a meaningful normative stance. The comparable term "compassionate classical liberalism" would approach oxymoronic classification. There is no halfway house here; other persons are to be treated as natural equals, deserving of equal respect and individually responsible for their actions, or they are to be treated as subordinate members of the species, akin to that accorded animals who are dependent.

Maclean doesn’t just get this quotation wrong—she edits it so that it says exactly the opposite of what Buchanan actually wrote.

This isn’t an aberration. It’s not a sloppy mistake in an otherwise well-researched book. This is Maclean’s modus operandi.

Russ Roberts highlights a passage from Maclean smearing the economist Tyler Cowen.

The weakening of the checks and balances” in the American system, Cowen suggested, would increase the chance of a very good outcome.” Alas, given the pervasive reverence for the US Constitution, a direct bid to manipulate the system could prove ‘disastrous’.

Maclean describes Cowen as “creating…a handbook for how to conduct a fifth-column assault on democracy.” A claim that will seem absurd to anyone familar with Cowen's work.

Compare that to Cowen’s original passage

While the weakening of checks and balances would increase the chance of a very good outcome, it would also increase the chance of a very bad outcome. Furthermore, the widely perceived legitimacy of the US Constitution suggests that such a change would involve disastrous transition costs.

As Roberts writes

MacLean left out the word “While” that begins Cowen’s sentence. Then she left off the key qualifier that completes the sentence — the point that the downside risk of weakening checks and balances is substantial. There is nothing here suggesting Cowen is in favor of weakening democracy or the Constitution. By quoting only a piece of Cowen’s sentence, MacLean reverses his meaning.

It would be easy to list a dozen more errors but Michael Munger, Christopher Fleming, Phil Magness and Greg Wiener have already done it for me.

Regrettably, The Guardian’s George Monbiot has been taken in by Maclean’s selective quoting and sloppy research.

I am sure it was not Monbiot’s intention to mislead his readership and I expect he will retract his article, clarify his mistake and apologise to the scholars who have been a victim of Maclean’s academic malpractice.

Clarification: Viktor Matheson points out that I misread PJ O'Rourke's reference to the US Department of Agriculture. There's one bureaucrat for every three farms not the other way round. Still too high, but not quite as extreme. I apologise if anyone was misinformed by this. 

Mrs Clegg tells us about Brexit - and gets it entirely wrong

One of the mystifications of the Brexit process is how many very clever people can end up believing things which are just simply not so. For example, Mrs. Clegg takes to The Guardian to tell us about negotiations over trade following our blessed exit:

It is easy to see why this government would be mesmerised by Legatum. It is keen on unilaterally removing tariffs and quotas on agriculture products (farmers, take note) in exchange for services agreements all over the world.

A lawyer should know the meaning of the word unilaterally. It means without being in exchange for something. We've no particular relationship with Legatum ourselves, although we obviously know them. And we too think that unilateral free trade is the way to go. As we did in 1846 with the Corn Laws. For imports are the purpose of trade, they're the very things that we conduct trade in order to gain access to. Taxing ourselves for the temerity to like Argentinian beef is simply ludicrous from the word go. Thus we shouldn't do it.

But it is worse than that:

The effect of this on food security and food prices was highlighted this week in a report published by the University of Sussex.

That's the report by Tim Lang et al which insists (no, not just assumes, insists) that we will have to impose "WTO tariffs" on food imports as we leave. This is to miss that there are no such things as WTO tariffs. What there are are maximum tariff levels that a WTO member may impose upon imports from another WTO member. Further, every WTO member is entirely at liberty to charge themselves anything they like less than these maximums. We did actually check this at source, Britain can indeed decide not to tax itself for access to French cheese. 

Lang's report insists that reversion to WTO terms means we must impose import tariffs, Lang is wrong. Given that it is this error which leads to his prediction of higher food prices Ms. Gonzalez Durantes is also wrong. Not that this is unusual in her circles as Mr. Clegg also suffers under the same delusion.

Brexit will not increase food prices, it will reduce them as we will be able to buy the best and cheapest food from the world, not have to cower behind the EU's protective barriers to trade.

What worries here of course is that these people, both Cleggs, Tim Lang and pals, various others, they insist that they are the Great and the Good who really know this stuff and we should just shut up and do as they say. The problem being that they're simply wrong, they believe things which ain't so.

 I have negotiated myself for the EU on many occasions on trade,

No wonder that EU trade system is such a crock, eh?