IMF: leverage best for determining bank bailouts

Leverage ratios, return on assets and stock data are among the most reliable indicators for predicting whether banks would require government intervention in the credit crisis, according to a study published by the International Monetary Fund (IMF) this week.

The IMF's Global Financial Stability Report included a review of the common factors among financial institutions that required public support during the current crisis, which examined balance sheets and stock information of 36 banks for common features shared by the banks that received support.

Leverage ratios were one of the aspects that gave indications of whether a bank would require public support. For example, non-intervened banks had an average ratio of debt to common equity of 7.6 between January 2005 and June 2007, compared to a ratio of nine for intervened commercial banks and 13.7 for intervened US investment banks.

Return on assets was another significant factor. For non-intervened banks, return on assets over the same period was 1.2%, compared with 1.6% for intervened commercial banks and 4.3% for intervened US investment banks. The IMF highlighted this could be linked to leverage ratios.

"While return on assets for the intervened institutions are much higher than those in the non-intervened commercial banks, suggesting elevated risks are associated with higher returns, return on equity has not captured any major differences between the financial institutions that were intervened or not. This contrast between the effectiveness of the two measures may reflect the high leverage ratio of intervened financial institutions, which typically rely on higher levels of debt to produce profits," the report said.

The IMF found stock market indicators were also able to capture some differences between the two sets of banks. The price-to-earnings ratios, earnings per share, and book value per share of the intervened investment banks were generally higher than those of the non-intervened banks. The IMF suggested the higher equity prices and earnings do not necessarily reflect healthier institutions, but perhaps indicate higher risks.

Meanwhile, the report dismissed other factors as not being so indicative of a need for government support during the current crisis, including liquidity ratios, capital adequacy ratios, and ratios of non-performing loans to total loans.

Regulators are currently working on a host of new rules to manage financial firms that pose a systemic risk to an economy and could require a government bailout during a major financial crisis. There is agreement that leverage ratios are one of the key factors of a risky institution, and supervisors have proposed drawing up new measures to control this.

The Basel Committee on Banking Supervision has said it will produce proposals by the end of 2009 for the introduction of a gross leverage ratio as a restriction on the growth of assets relative to capital.

"We need the risk-based measure to interact with a simple metric that can act as a floor and help contain the build-up of excessive leverage in the banking system, one of the key sources of the current crisis," said Nout Wellink, chairman of the Basel Committee, in a speech before the European Parliament's Committee on Economic and Monetary Affairs on March 30.

The introduction of maximum leverage ratio was also supported by Adair Turner, the chairman of the UK Financial Services Authority, in The Turner Review, a report published in March on the financial crisis and possible regulatory responses.

See also: Regulators square up to leverage ratio challenge
FSA plans new capital formula for banks