The Era of Leverage is over

A few years ago, senior officials at the Bank for International Settlements started ringing alarm bells about the scale of leverage that was quietly building up in the financial system. Back then, though, it was fantastically hard to get American policymakers – let alone bankers – to listen.

In the go-go days of the credit bubble, Washington policymakers blithely assumed that the Western financial system had plenty of capital to cope with any potential risks. Consequently, as one former BIS official admits: "Worrying about leverage wasn't fashionable at all – no one wanted to hear."

Fast-forward a couple of years and, my, how those Western financiers are having to eat humble pie (even to the point of accepting a helping hand from the once-ailing Japanese). After all, the events of the past year have now made it patently – horrifically – obvious that the Western banking system has become dangerously undercapitalized in recent years, to the point where even the Federal Reserve is having to shore up its defences.

Moreover, it is now also clear that Western policymakers are belatedly trying to correct this state of affairs. The days when high leverage, mega bonuses and wacky instruments were equated with financial virility have gone; instead a more humble, back-to-basics and slim-line approach is what investors are demanding. Thus, deleveraging is now all the rage – in whatever form it might take.

The news that Morgan Stanley and Goldman Sachs – which were the last surviving big investment banks on Wall Street – have become regulated banks is a particularly compelling sign of this trend. On a micro level, the move packs a powerful historical punch, since it essentially spells the end of the old broker-dealer business model, with its bold, buccaneering approach to life.

In a broader sense, it also provides further evidence that the era of high leverage is over. After all, one key factor that has marked the brokers out in recent years is that they did not face the type of strict leverage rules that were applied to US commercial banks. Thus, while the latter group was generally forced to keep tangible equity at 5 per cent of assets, or more, brokers operated with a lower equity ratio. That let them have leverage ratios of more than 30 times – which in turn turbocharged their profits.

The regulatory controls on the commercial banks have sometimes produced disagreeable side effects – most notably encouraging banks such as Citi to create a plethora of off-balance sheet vehicles, such as the now notorious structured investment vehicles.

However, these rules also meant that groups such as Citi, JPMorgan Chase and Bank of America started the crisis with more ammunition. And Sunday's news shows that Goldman Sachs and Morgan Stanley now recognise they must do the same, if they are to survive.

Moreover, they are not the only ones facing a slimmer life. Over in Switzerland, the central bank now wants to impose a comparably tough leverage ratio on groups such as UBS (which, remarkably, has been operating with even more leverage than some US brokers in recent years).

Separately, international regulators in Basel are now tweaking the so-called Basel Two capital rules to force banks to hold more capital against esoteric assets. And efforts are now under way to toughen the rules for a putative central clearing house for credit derivatives – which, in turn, would prompt lower leverage in that sector too.

In the long term, all this is utterly desirable. Indeed, it is also overdue. However, nobody should forget that the shift also presents policymakers with yet another headache. After all, even at the best of times, deleveraging is never an easy process; and right now, it threatens to produce a particularly unpleasant downward drag on asset prices and growth.

Some industry analysts estimate, for example, that if investment banks were to cut leverage ratios from 30 times (or recent levels) to 20 times, this would trigger $6,000bn worth of asset sales, excluding likely deleveraging by hedge funds too.

Of course, such deleveraging will not happen overnight, or necessarily in such a simplistic way. But what these rough calculations show, as George Magnus at UBS points out, is that the putative $700bn RTC fund cannot be considered an all-encompassing solution to the current woes. Deleveraging, in other words, still has a long way to run – at Morgan Stanley and Goldman Sachs, for starters.

By Gillian Tett for FT