Dangerously low leverage ratios were one of the main causes of the 2008 financial crisis. The post-crisis regulatory response — Basel III and its EU implementation CRD IV — was supposed to fix this. It hasn’t.
This paper argues that most major UK and European banks remain perilously thinly capitalised, with leverage ratios averaging between 3% and 5% across systemically important institutions. Each pound or euro of equity supports between twenty and thirty-three pounds or euros of assets. Even very small falls in asset value could wipe out the equity of these banks — and trigger another round of taxpayer bailouts.
Key findings:
- Official stress tests are flawed by design. Both the ECB and Bank of England stress tests rely on risk-weighted asset measures that banks have strong incentives to game, and on scenarios too mild to reveal true vulnerability. A stress test using actual asset value drops from the 2008 crisis shows that, without assistance, all major European SIFIs would see leverage ratios fall to 1.5–1.7% — well below the level at which Lehman Brothers failed.
- Germany and France, not the periphery, are most at risk. Contrary to the ECB’s narrative, French and German banks are the worst capitalised by the leverage ratio metric. The ECB’s preferred CET1/RWA metric flatters core Eurozone banks relative to peripheral ones.
- Implicit subsidies distort incentives. The too-big-to-fail guarantee, tax deductibility of debt interest, and deposit insurance together create a system where profits are private but losses are socialised. Without these subsidies, there is no evidence of economies of scale at bank sizes above $100bn.
- The fix is simple but resisted. Academic consensus suggests leverage ratio requirements of 15–30% — far above the Basel III minimum of 3%. Banks resist this because it would transfer risk back to shareholders from taxpayers. The EU’s regulatory structure makes it difficult for member states to impose stricter requirements unilaterally.
Written under the supervision of Professor Kevin Dowd (Durham University) and published by the UKIP Parliamentary Resource Unit.