The Trump administration has been actively working on retooling the leverage ratio for big-banks moving forward. This will curb excessive borrowing and serve to provide more freedom for large lenders to expand in areas they once lacked. This does not mean that banks will be allowed to take on excessively risky projects, the capital rules and regulations from the past will still hold. This is great news for banks as the current leverage strategy discourages bankers from taking on many low-risk activities.
The Federal Reserve and the Office of the Comptroller of the Currency have been closely working with the Trump administration to lower the leverage ratio. This will positively affect cash flows and return more profits for shareholders. This will also be implemented in the future stress testing models for the big banks. A recalibration is just the first step to transformation; the Trump administration is also working with appointed officials to redesign the Volcker ruler proprietary trading ban and other liquidity regulations.
Officials state, “We haven’t had a recession since 2008, so from one point of view, our ‘too big to fail’ banks have never really been tested. However, a booming economy can lead to a relaxation in lending standards and an attendant increase in risky debt levels.”
Bank capital levels are measured in two primary ways, risk-weighted indexes and leverage ratios. Risk-weighted rules give each asset different values, thus making banks fund mortgages with more equity than bonds. On the other hand, leverage ratios simply compare a bank’s equity to its total assets. The 2008 crisis proved that the risk-weighted index needed to be re-written and that the leverage ratios needed tightening. However, the problem with a strict leverage ratio is that it treats relatively safe, low-margin projects the same as riskier and more profitable ones. This is not a good representation of the risk-return strategy and gives bank’s less room to pursue smaller activities with low risk.
One question to dig deeper into is whether banks will use the recalibration of the leverage ratio to grow the overall business or draw down capital and send it to shareholders. Drawing down capital will be a major problem for bank’s because it would mean less equity to absorb losses in the future if a potential downturn occurred. Moving forward, it will be up to the decisionmakers at these big banks to successfully navigate the new and upcoming policies.