The shocking reality of leverage ratios

The Turner report, published by the Financial Services Authority, is proving to be a rich seam of outrageous charts. Indeed, it is ironic that the authority produced the most definitive assessment of the crisis while the industry it was supposed to supervise is teetering on the brink of collapse.

If only it had produced a similar analysis five years earlier. Perhaps it might have done something about the unconscionable behaviour of UK banks. I know - "should have; could have; would have" - it's all too late. The greatest financial crisis in a century is now upon us, and regret doesn't help much.

Nevertheless, it does no harm to the back in horror at what the banks were doing over the last 10 years. Perhaps the best guide to banking sector irresponsibility is the leverage ratio. Banks invariably prattle on about risk weighted capital adequacy ratios, but the thing that really matters is leverage - the ratio of bank assets to capital.

Regrettably, it is now all too clear that investment banks pushed their leverage ratios to insane levels. Capital is the buffer that allows banks to a absorb losses. If a bank has a leverage ratio of over 30, it will become insolvent if only 3.5 percent of its assets become unrecoverable. According to the FSA, UBS had a leverage ratio in excess of 40 over the last four years. This is the banking equivalent of playing Russian roulette.

(click on the chart for a sharper image)

As the Turner report confirms, the major investment banks had leverage ratios hovering between 20 and 30. However, the picture within the retail UK banking system is both more horrifying and more complex. UK banks have a long history of comparatively high leverage ratios. On average, that ratio has been at least 20, although it has been creeping up in recent years.

However, the average is just a measure of the midpoint. As the FSA painfully points out, some banks have ratios considerably higher than 20. In fact, according to the Bank of England, one bank had a leverage ratio in excess of 60. Moreover, the variability of leveraged ratios has been growing that some time. Some UK banks were prudent; other banks had a death wish.

Looking at these charts, there appears to be a strong element of naivete. There is something childlike about a bank that pushes up its leverage ratio when the economy is booming and it is easy to produce profits. It betrays an immature and untutored belief that the world is a calm and benign place, where nothing can go wrong and where everything will turn out just right.

It was as if banks were living like a fairy tale princess, who used a magic spell that made that that nasty dragon, known as risk, disappear. However, risk could not be wished away. It has returned like an avenging psychopath from a slasher movie.