The current enthusiasm for simpler measures of banks’ capital solvency is understandable but dangerous. Abandoning risk-based measures in their favour could make the financial system less safe while simultaneously impeding the flow of credit to the real economy.
Take the so-called “leverage ratio”, whose main selling point is its simplicity. There is no risk-weighting of assets. It measures a bank’s capital against a straightforward accounting definition of its assets. Yet this means a dollar of very low-risk assets backed by collateral is treated exactly the same as a dollar lent to a risky borrower on an unsecured basis. So as a true measure of solvency, the leverage ratio fails since it tells you nothing about the nature of the assets.
Moreover, treating risky and safe assets the same way when deciding how much capital banks should hold will have predictable consequences. Banks will shed safe assets with low returns (since they will have to put too much capital against them) and focus on riskier products and segments with higher returns.