According to the Basel III regulatory framework of the Basel Committee on Banking Supervision, banks should maintain a tier 1 leverage ratio of at least 3 percent. Additionally, global systemically important banks in the United States (U.S.-GIBs) must comply with a set of rules called the supplemental leverage ratio (SLR), which is set at 5 percent. These institutions will have to publicly disclose their compliance with both SLR and Basel III leverage ratios by New Year’s Day. Thus, the requirements for U.S. G-SIBs are substantially more stringent than those that apply to their overseas counterparts. Yet that could change soon because European regulators are under pressure from officials around the world to impose stricter rules on continental banks.
Leverage ratios have often been criticized for their use as a measure of bank strength. They are regarded as a rigorous test but do not take loan risk into account. However, leverage tests have been the basis of many costly regulations imposed on the banks in the wake of the crisis, and they’ve contributed to the weakness in lending seen in recent years. The brunt of these regulations has fallen on G-SIBs, which are reducing their risk-weighted asset bases by changing how they raise capital for operations. Many banks have retained profits or issued new shares to comply with the new regulations instead of raising capital by debt. Investor returns have also been hurt because the tighter regulatory regime has reduced dividend payouts and curbed share repurchases.
As we can see from the accompanying chart, return on equity has been trailing for all the banks since the regulations were implemented, although broader economic conditions have factored into this trend as well. Wells Fargo is the only bank whose ROE even slightly surpasses the tier 1 capital ratio. In this environment, many banks are trying to shift away from traditional lending toward lines of business with lighter public oversight, such as asset management. These new approaches are meant to ensure profitability as well as move banks outside the focus of regulators, who, after all, are attempting to avoid the mistakes that contributed to the financial meltdown.
Sources: Bloomberg, Milken Institute.