…Norton asks whether the U.S. should continue to rely heavily on sophisticated risk-based measures of assets to calculate the adequacy of what is known as “regulatory capital ratios.” Or, instead, should greater emphasis be placed on the simpler, more straightforward measure of “leverage” — meaning how much equity a bank has relative to its assets, without any risk adjustments (or, equivalently, how much debt versus equity the company has on the liabilities side of its balance sheet)?
Norton prefers to focus on leverage, which is simpler to assess and easier to monitor. Risk weights are always wrong, often with dire consequences, as we saw with mortgage-backed securities, collateralized-debt obligations or Greek sovereign debt. During the 2007-08 financial crisis, Norton said, “the markets rejected the existing Basel risk-based capital measurements in determining a bank’s likelihood of default.” Yet the latest evidence suggests the banks are again “optimizing” their capital, essentially gaming the rules to be able to take on more risk.
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