Philipp M Hildebrand: Is Basel II enough? The benefits of a leverage ratio Speech by Mr Philipp M Hildebrand, Vice-Chairman of the Governing Board of the Swiss National Bank, at the Financial Markets Group Lecture, London School of Economics, London, 15 December 2008. * 1. *  *  Introduction  It is a pleasure to be at the London School of Economics this evening. I am very grateful to Professor Goodhart for his generous invitation. As many of you know, Charles is a kind of godfather to an entire generation of central bankers. His 1988 book, The Evolution of Central Banks, remains a classic and is still required reading for aspiring central bankers. Let me take this opportunity to thank Charles for tonight’s wonderful platform and, more importantly, for his long-standing contributions to the art, science, and craft of central banking. Recurring financial crises have become a hallmark of the modern financial system. It would seem that, every five years or so, a 100-year event destabilises the system. Moreover, each crisis appears more violent than the previous one. With the current crisis as my showcase, I will argue that excessively high leverage has been a key factor in making banks and ultimately the financial system much more fragile and vulnerable than most observers, regulators, or market participants ever imagined. Based on this diagnosis, I will argue in favour of restricting the leverage of core financial institutions, i.e., banks. Needless to say, banks have a tendency to oppose regulation.
In Switzerland, in a recent reform of the large banks’ capital requirements, the Federal Banking Commission embarked upon a pragmatic approach to address this dilemma. In normal times, banks will be required to hold capital significantly in excess of the regulatory minima. Conversely, when the cycle turns, they will be allowed to dip into the capital cushion. Naturally, the Swiss authorities are acutely aware that imposing tighter capital requirements right now would be pro-cyclical. Under the new regime, the capital requirements have to be met by 2013. If necessary, this implementation window will be extended further. •  Finally, let me address the question of banks’ profitability: This is a tricky question, which requires a two-part answer. 21  6  o  First, capital requirements effectively reduce the value of a bank’s explicit or implicit government safety net. If we think of the safety net as a put option for the owner of the bank, capital requirements effectively reduce the price of that put option. In other words, banks have to bear a larger share of their potential losses themselves. This, of course, is bad news for the banks. Distortions due to the safety net are the main rationale for capital regulation. Capital requirements aim to correct these distortions and strengthen the motivation of banks to avoid excessive risks. While this comes at a cost to banks, it increases overall efficiency and economic welfare. o  Second, capital requirements reduce the tax shield of debt.