How a supplemental leverage ratio can improve financial stability, traditional lending and economic growth

Financial stability and economic growth are complementary, not mutually exclusive. A stable financial system supports prosperity and growth. As we saw from the global financial crisis, an unstable system destroys value and reduces a willingness on the part of banks to lend and engage in prudent risk-taking. However, as the American economist Hyman Minsky pointed out decades ago, protracted stability can also become destabilising as market optimism begets more optimism, borrowing leads to more borrowing, and eventually re-pricing and collapse. Credit cycles can serve as an important reminder of the risk of loss inherent in financial activity thereby tempering investment and lending decisions with a good dose of due diligence and caution. Accordingly, policymakers should foster financial systems that are flexible and resilient enough to function through the cycle. Such systems should use simple, common sense constraints on optimistic excess in good times, while helping ensure a robust loss-absorbing buffer and capacity to lend, during downturns. Perhaps the most important financial stability tool that promotes these goals is a supplemental leverage ratio: a simple leverage requirement used alongside a risk-based capital framework to improve resiliency, loss absorbency and to address shortcomings in the risk-based capital framework. The paper will highlight how, used in conjunction with a risk-based approach, a supplemental leverage ratio, like the one recently finalised by financial regulators in the United States, can support traditional lending and provide meaningful loss absorbency and lending capacity to make sure the financial system continues to function during downturns.