The frequently mentioned minimum capital ratios according to Basel-2 are something different. First, they are expressed as “percentage of”. For example, a 9% capital ratio means that the bank must maintain capital (a more narrow definition of equity) of at least 9% of risk assets.
The trick is that Basel-2 excludes certain risks from “risk assets”. For example: Basel-2 deems sovereign debt to be risk-free. Thus, no reserves need to be held against it and it does not count as risk assets in the minimum capital calculation.
As an extreme example, a bank might have a Basel-2 capital ratio of 15% (far above the minimum required) but it might have, at the same time, a leverage of 20 to 1 (which is very high as explained below). How could that be? It would happen if the bank held a very large amount of sovereign debt.
A traditional banker would disregard the sophisticated Basel-2 definitions and simply ask “What’s the bank’s leverage?” The higher the leverage, the greater the risk. Every financial claim on a bank’s asset side represents risk, even if it is the sovereign debt of a AAA-rated country. Why? Because assets need to be funded; the higher the leverage, the greater the funding risk.
There are no regulations as to how high a bank’s leverage can be. A general rule is that it should not be too much above 10 to 1. Another general rule is that a leverage of 20 to 1 or more should be reserved for hedge funds.
Below is the leverage calculation of two banks each from the US, France and Germany.
JP Morgan: 11 to 1
Citigroup: 9 to 1
BNP: 22 to 1
Credit Agricole: 21 to 1
Deutsche Bank: 39 to 1
Commerzbank: 26 to 1
A sample of two per country isn’t necessarily a good basis for a theory but the two banks chosen do indeed reflect very much of the banks’ structures in these countries.
The European banks are at least twice as much leveraged as the US banks. All of them are clearly in the category where one would expect hedge funds to start but Deutsche Bank would even be a trend-setter among hedge funds.
These kinds of hedge funds are the institutions which European tax payers (including Greek tax payers) have been bailing out over the last 2-3 years (and if Mr. Draghi get his way, they will even do much, much more bailing out of hedge funds).