A historical account of leverage ratios in the Dutch banking system

In recent years there has been a robust debate in The Netherlands, as well as in many other countries, regarding the desired level of leverage ratios in the banking system. The leverage ratio is the percentage of equity held by a bank relative to its unweighted total assets. Partly due to an article by the Dutch Central Bank (De Nederlandsche Bank, DNB), there is an impression that this ratio has declined sharply in the Netherlands over the past 100 years (DNB, 2010). The suggestion was that bank leverage ratios had become too low and that this was a negative influence on the stability of the banking system.

There is quite a divergence of views in this debate. In 2010, in response to the crisis the Basel supervisory committee proposed among other things that banks should hold equity of at least 3% of their total assets. The Dutch Minister of Finance has argued at European level that the minimum should be 4%, and this requirement will apply in the Netherlands with effect from 2018. On the other hand, some people, mostly academics, argue that banks should, like ‘ordinary’ companies, hold equity of at least 20 or even 30 per cent of their total assets (Admati et al., 2013). According to them, this would be more in line with the situation of around 100 years ago, as shown for commercial banks in the Netherlands in figure 1.

We begin this Special with a discussion of the forces behind the development of leverage ratios. We then turn to the historical context in which the decline in leverage ratios identified by DNB has occurred, followed by further consideration of the DNB study and its conclusions.

This article focuses mainly on the development of leverage ratios between 1900 and 1990, since most of the decline noted in the DNB study happened in this period. Furthermore, there have been so many changes since 1980 in areas such as banking supervision, the international environment in which banks operate, the role of derivatives and the reporting rules that banks must observe that this period requires a separate and more detailed analysis.

A frequently mentioned theme in the discussion is the motivation of businesses, and thus banks as well, to optimise their capital structures (Modigliani & Miller, 1958). Operating with a high level of debt enables them to benefit from what is known as the leverage effect, that boosts return on equity. The fact that governments in many countries tax debt leniently encourages businesses to hold relatively low levels of equity.

A point that is often not given enough consideration in the discussion of the bank leverage ratios is the fact that a large proportion of a bank’s liabilities consist of cash held by the public (both private individuals and businesses) in current accounts and savings. DNB notes this aspect as a specific factor applying to banks, calling it the ‘public preference for liquidity’ (DNB, 2010, p. 40), which to some extent explains why banks operate with a low level of equity compared to other businesses. Of course, this public preference for liquidity only affects a bank’s balance sheet if it leads to people holding overnight deposits (current accounts) or savings at a bank. We use the term ‘funds entrusted’ for the sum of current and savings accounts. A preference for currency in circulation would not have any such effect. But if the public’s preference for liquidity is one factor explaining the level of leverage ratios, a relevant question would be: what would be the effect of a change in this liquidity preference for the development of leverage ratios?

Before looking at historical leverage ratios in more detail, we will look at the question of what the development of the leverage ratio tells us about the stability of a bank. A very stylised example can serve as an illustration. Figures 2 and 3 show the asset and liability sides respectively of a very simple bank balance sheet in five scenarios. The first scenario is the opening balance sheet in our example. The bank has total assets of 10,000 with equity of 2,500. The leverage ratio in this opening situation is therefore 25%. There are then four scenarios in which the balance sheet increases on each occasion by 5,000 and the leverage ratio falls to 17%.

Scenario 1)

In the ‘money creation’ scenario the balance sheet increases by 5,000 due to an increase in lending as a result of mutual acceptance of debt. The loans item on the asset side of the balance sheet accordingly increases by 5,000. The funds entrusted item on the liability side increases by the same amount.

Scenario 2)

In the ‘substitution’ scenario the funds entrusted item increases by 5,000 because people deposit money in circulation (bank notes) in their current accounts. At the bank, the item of cash on the asset side increases initially by the same amount.

Scenario 3)

In the ‘savings bank’ scenario, we see a pure secondary bank that does not offer current accounts and funds all its lending by raising already existing savings. On the asset side, the loans item rises by 5,000, and on the liability side the funds entrusted item also rises by 5,000, just as in scenario 1. Please note that the ‘savings bank’ is the only one that also does not offer current accounts in the starting situation. All its funds entrusted consist of savings deposits.

Scenario 4)

In the ‘credit bank’ scenario we see a bank that funds the increase in its lending entirely by raising loan capital in the capital market. The lending therefore does not affect the funds entrusted item, but the item other loan capital is affected.

At first glance, the scenarios look very similar. The leverage ratio declines in all scenarios due to the 5,000 increase in the bank’s balance sheet, from 25% to 17%[1]. Nonetheless, the nature of the banks changes in the four scenarios in a rather different way. In scenarios 1) and 3) the asset and liability sides of the balance sheet appear to be identical. Both show an equal growth in the loans item. The difference is that in the case of the savings bank, all the funds entrusted consist of savings. Assuming that these savings are not callable on demand, the liquidity risk of this bank is lower than that of the bank in the ‘money creation’ scenario. The liability side of the bank in scenario 2) ‘substitution’ is identical to that of the bank in the ‘money creation’ scenario, but the asset side is completely different. Since here the growth in the balance sheet on the asset side is entirely reflected in the cash item, this bank is exposed to significantly lower credit and liquidity risk than the banks in the other scenarios. The bank in scenario 4) funds the growth of its lending entirely by raising loan capital in the financial markets. Under the generally held assumption that this source of funding is less stable than savings, this bank accordingly has a higher risk profile than the banks in the other scenarios.

To recapitulate, we see in this very simplified example four banks with identical total assets and identical leverage ratios but with different risk profiles, whereby the bank in scenario 2) has the lowest risk, followed in order of increasing risk by the ‘savings bank’ in scenario 3), the ‘money-creating bank’ in scenario 1) and the ‘credit bank’ in scenario 4). This is the case while the three last-mentioned banks have the same loan portfolios in terms of size and, as we assume, risk profile.

Another simple but certainly not unrealistic example can be derived from what can happen during a banking crisis. Assume at an unfortunate moment that there is a loss of confidence in a bank and customers decide en masse to withdraw their savings and transfer them to a bank where they feel their money will be safer. There will be a run on the bank considered to be unsafe and its balance sheet will be diminished, unless of course the central bank intervenes and provides the bank with additional liquidity. We assume that the central bank refrain from intervening. This bank’s leverage ratio will rise as a result of the decline in its balance sheet. The safe bank will receive a huge inflow of cash and its balance sheet will increase. Its leverage ratio will then decline. In a scenario of this kind, the leverage ratio therefore does not provide correct information.

The lessons of this are: firstly, that a bank’s leverage ratio can undergo substantial change as a result of its regular banking business, such as lending, money creation and substitution of money in circulation into money in bank accounts. Customer behaviour can thus have a significant effect on its own. Secondly, the leverage ratio gives only relatively little insight into the actual risk profile of a bank. It is an unweighted and therefore rough measure that does not provide any insight into the underlying risks of a bank’s assets and/or its funding structure. Thirdly, the leverage ratio can give completely wrong signals, as shown above.

[1] In the initial situation, the leverage ratio was 25% (2,500/10,000). In the scenarios the total assets increase to 15,000, while the equity remains unchanged. This leads to a decline in the leverage ratio to around 17% (2,500 /15,000).

Before we go deeper into the development of the leverage ratio of Dutch banks since 1900, we first have a closer look at the Dutch financial system of 100 years ago and the subsequent changes. Over 100 years ago, almost all transactions were settled in cash and people still held relatively high amounts of their assets in cash, securities or physical form. Even interbank payments were still largely settled in cash in those days. Cash payments between private persons and/or businesses have no effect on the size or composition of commercial bank balance sheets.

However, the payment behaviour of Dutch people has radically changed since the beginning of the 20th century. Since the foundation of the Amsterdamse Gemeentegiro in 1917 and the Postcheque- en Girodienst in 1918, payments by fund transfers have increasingly taken off. Nowadays, the majority of payments traffic consists of funds transfers settled by the banks and the vast majority of savings are held in bank accounts. From the banks’ point of view, this entails a liability to the customer and thus is debt. The rise of payments traffic by funds transfer is therefore to a certain extent an independent driver behind the increase in bank balance sheets and the ever-increasing proportion of debt in those balance sheets. To a certain extent, since the banks of course are increasingly encouraging payments by funds transfer.

Secondly, there is the question of how much DNB’s analysis, which is based on data relating to the commercial banking category, is distorted by a composition effect. Given the nature of their activities, one could expect to see at the beginning of the last century that many commercial banks settled almost no transactions via funds transfers and held no retail savings. If people held financial assets in the form of bank balances, this was at a general savings bank or at the Rijkspostspaarbank founded in 1881, apart from very high net worth individuals. Many small business owners had a banking relationship with an agricultural credit cooperative (the predecessors of today’s Rabobank), a small business bank (a sub-category of the commercial banks) or, since 1927, the Nederlandsche Middenstandsbank (NMB, one of the predecessors of today’s ING). One might expect that as a result of the nature of their business these institutions also operated with lower leverage ratios 100 years ago, and that the rapid growth of their businesses by definition has had a downward effect on the development of the average leverage ratio.

From commercial banks to universal banks

As noted above, DNB based its analysis on the balance sheets of what are known as the commercial banks (box 1). At first sight, this would seem to be an obvious choice. It is the oldest and in numbers also the largest group of banks, and at the beginning of the 20th century it was also the largest in terms of total assets (figures 4 and 5). This group ultimately ended up in the universal banks category. While the choice of this group of banks, for which a relatively large amount of reliable information is available, is perfectly reasonable, there are some points which need to be made. Firstly, while the commercial banks are a large group, they are mostly small banks with a huge variety of activities (DNB, 2000). They were small independent financial institutions, such as banking houses, cashiers, provincial banks and colonial banks. Most of them were limited in both the type of activities they undertook and their regional range. Being mostly small and independent institutions, they were vulnerable to setbacks, which, given the absence of a well-developed interbank market and a lender of last resort, forced them to be heavily capitalised. But what is more important for our analysis is that the liquidity function of many commercial banks was usually underdeveloped and the liability side of their balance sheets consisted of relatively low levels of funds entrusted.

This meant that the group of commercial banks, which itself included several categories, was highly diverse, with the SME banks for example having completely different balance sheet structures and much lower leverage ratios than other commercial banks (see box 2). This is logical, since they attracted larger groups of small businesses from their working areas that held some of their financial assets at the bank. The same applied to the agricultural credit institutions, that did not belong to the commercial banks category and served many small agricultural and traditional businesses. As a result of their strong emphasis on the liquidity function they fulfilled for their customers, it is no surprise that not only they, but also a bank such as the NMB founded in 1927, operated from the start with much lower leverage ratios than the average commercial bank (figure 6).

The same applied to other banks offering savings products, such as Rijkspostspaarbank and the general savings banks. The former actually operated from its incorporation in 1881 until 1925 with virtually no equity of its own. Since almost all the assets of Rijkspostspaarbank consisted of claims on the government and these were carried at book value, a risk weight of 0% was apparently considered to be acceptable at the time.

One aspect that does not feature adequately in the discussion is the fact that commercial banks did not only become larger gradually through growth, mergers and acquisitions. After the Second World War, they also increasingly developed into universal banks. The same applied, albeit to a lesser extent, to the savings banks and the agricultural credit institutions. There was increasingly a blending of categories and banks started to encroach on each other’s areas of operation (Boonstra & Groeneveld, 2006). After the huge boost to funds transfer payments traffic after the Second World War and its aftermath, the use of funds held in bank accounts and savings really took off (see below). Commercial banks increasingly focused on private customers. Part of the decline in their leverage ratios was due to the rapid growth of funds held in bank accounts (both current and savings accounts), also known as funds entrusted, that were held on the liability side of their balance sheets. The various categories of banks gradually converged, towards becoming banks that had started life with low leverage ratios as a result of their important intermediary function (figure 7)[2]. Rabobank has belonged to the commercial banks category only since 1986. This had already applied to the central cooperatives before that date, but not to the member banks, even though they were the ones doing most of the customer-oriented business (DNB, 2000).

[2] The figures in the annual reports of Coöperatieve Centrale Raiffeisen-Bank between 1962 and 1968 were not split for the affiliated banking business.

One last aspect concerns the internationalisation of the Dutch banking system after World War II. Among the commercial banks, there was a rapid increase in the importance of foreign business from 1960 onwards, on both the asset and the liability side of the balance sheet. The statistics used (DNB, 2000) do not show whether the foreign liabilities arising from payments traffic concerns interbank items or also loan capital issued abroad. This requires further study.

Don’t forget to mention the war!

What DNB and many others have pointed to is the sharp decline in the leverage ratios of the banks in the second half of the 20th century. What everyone has so far ignored in the current debate on leverage ratios is that most of this decline actually took place between 1939 and 1945. So, the question is: what happened in the Netherlands from a monetary point of view during the war years, and how did this affect the leverage ratios of the Dutch banks?

The sharp decline in the leverage ratios of the Dutch banks between 1939 and 1945 occurred against the backdrop of explosive growth in total banking assets that was not accompanied by a proportionate increase in equity. The context in which this development took place was of course the occupation of the Netherlands by Germany between May 1940 and May 1945. Without going into too much detail here, it was the case that the money supply quadrupled in this period. This was due to a massive monetary financing of government spending (Klemann, 2008; Van Zanden, 1997). The banks’ balance sheets grew enormously during these years. On the asset side, this growth was more than fully explained by the claim on the Dutch government, and on the liability side there was huge growth in funds entrusted. The money purge that took place after the war also contributed to this. One aspect of the Beschikking Deblokkering (Deblocking Decree) 1945 that has not received enough attention is that this measure basically forced every household to open a bank or giro account (Mooij & Dongelmans, 2004, p. 57).

Table 1 in the appendix shows the change that took place for the commercial banks and the agricultural credit institutions between 1939 and 1945. During this period there was a huge increase in total bank assets. On the asset side, this can be amply explained by the explosive growth in claims on the government. On the liability side, there was a huge increase in funds entrusted. The result, of course, was a steep decline in de leverage ratio of all categories of banks. After the war, the leverage ratios of the commercial banks, which in these decades were becoming increasingly involved in retail banking, declined further to levels comparable to the previous levels at the agricultural credit institutions.

Banking failures

The current debate suggests a relationship between the leverage ratio and banking failures. Looking at the Netherlands we found that 76 commercial banks closed their doors between 1900 and 1990. The vast majority of these failures, 64, occurred in the period between 1900 and 1940 (DNB, 2000, p. 102). This was the time when the average leverage ratio at a commercial bank was still between 20% and 25%. Compare this to the agricultural credit institutions, not one of which went bankrupt during the same period, even though many of them were operating with leverage ratios of less than 5%. This illustrates that a diversified business, close attention to the quality of the banking assets, stable funding and access to good interbank and/or lender of last resort facilities are more important that the level of the leverage ratio alone. This is also shown by the analysis above using the simple examples in figures 2 and 3.[3]

[3] These figures should of course be interpreted with the necessary degree of caution. One of the biggest banking crises ever in the Netherlands was the loss of the Robaver in 1924. Even then, this was not a bankruptcy in the formal sense, since the government stepped in secretly to provide this bank with strong support. As a result, a search for this crisis in the statistics will be in vain (Petram, 2016). There will also doubtless have been problems at the credit unions during this period, however they were kept going by their central organization or a stronger fellow bank.

This analysis is, as stated above, limited to roughly the period between 1900 and 1990. There are some provisional conclusions to be drawn. The first is that the perception that leverage ratios have substantially declined in this period across the board needs to be corrected. Many banks, especially those that from the start have focused on servicing retail customers (private persons and small businesses) were already operating more than 100 years ago with relatively low or very low leverage ratios. This was also because the liability side of their balance sheets also consisted mainly of funds entrusted at that time. Since these banks were not part of the series of commercial banks on which DNB’s analysis is based, they have been ignored for a long time. This was especially the case for the agricultural credit institutions until the 1980s.

Second, the greatest decline in leverage ratios occurred between 1939 and 1945, during the Second World War. This applies to all the categories of banks, but was most noticeable at the commercial banks. All this bore little relation to the ‘optimisation’ of balance sheet structures by the banks: it was a direct result of the high-inflation environment in which the banks had to operate and the money purge that took place after the end of the war. The explosive growth in balance sheets was amply explained by the fact that banks accepted large quantities of short-term government paper while on the liability side there was a huge increase in funds entrusted.

Third, it turned out that payments traffic by funds transfer was an independent force behind the growth in bank balance sheets and thereby the increase in loan capital. The change in liquidity preference from funds in circulation to funds held in bank accounts was therefore a factor causing leverage ratios to fall in the period until 1980.

Fourth, a high leverage ratio provides no guarantee of stability. In both absolute and relative terms, by far the most banking failures have occurred among the commercial banks, despite the fact that on average this is the group of banks with the highest capitalisation.

Fifth, the predecessors of today’s major Dutch banks, ING, Rabobank and ABN AMRO, have carried on their banking business without difficulties in the post-war decades with leverage ratios of roughly between 3% and 7% of their balance sheets. There were several recessions in this period, years featuring high inflation and international debt crises, none of which led to serious problems.

Lastly, the dominant impression is that the minimum leverage ratio of 3% currently agreed in the BIS context is indeed on the low side historically speaking, and one may therefore conclude that a gradual increase towards 5% would be advisable (Fender & Lewrick, 2015; Grill et. al, 2015). However caution is appropriate here as well, since the traditional leverage ratio from both the above analysis and the DNB study (2010) cannot be applied directly to the current debate. These days, the leverage ratio is calculated as the total assets plus certain off-balance sheet activities of the banks, while the calculation of equity includes certain forms of ‘bail-inable’ capital. Today’s so-called ‘fully loaded’ leverage ratio is different from the traditional straightforward measure used a decade ago.

It is also important that policy should be directed on the basis of capital ratios based on risk-weighted assets, since if correctly formulated this will give banks the right incentive in directing their business. Moreover, risk-weighted assets are a more realistic reflection of underlying risk. An unweighted leverage ratio is too rough, although it is still useful as a back-up as it does give a good indication of the extent to which banks can withstand serious shocks. But a ‘return’ to unweighted capital ratios of 20% or even 30% is not needed. There is no ‘return’, as this has never applied to the Dutch retail banks.

Further study

In addition to the data collected by DNB, our analysis is based on the balance sheet data of a series of individual Dutch banks. At this point, it mainly concerns the banks that can be considered to be the main predecessors of today’s major banks, namely ING (Nederlandsche Middenstandsbank), Rabobank (Boerenleenbanken and Raiffeisenbanken) and ABN AMRO (Amsterdamsche Bank, Rotterdamsche Bank, Amro Bank, Twentsche Bank, Nederlandsche Handel-Maatschappij and ABN). Our database is still under construction. Once this is complete, hopefully we will be able to provide a more detailed picture of the drivers behind the balance sheet ratios of the major Dutch banks and their predecessors.

In more recent decades, there have been many changes that could have had their own impact on the behaviour of the banks, the composition of their balance sheets and the relevance of leverage ratios. These include the introduction of the risk-weighting of assets, the BIS ratios based on this approach, the later introduction of liquidity requirements such as the Net Stable Funding Ratio (NSFR) and the Liquidity Coverage Ratio (LCR) under Basel III, the increase in the derivatives item and the introduction of the ‘bail-in’ regime. For a better understanding of the development of leverage ratios in the decades before the 2008 crisis and the drivers behind this, a more detailed study is needed based on the balance sheets of the individual banks concerned. The banks have indeed adjusted to the stricter capital requirements under Basel III in different ways. The specific adjustment in each case is associated with the development of bank lending and therefore directly affects the real economy (Bruinshoofd & van Nimwegen, 2016).

Furthermore, there is of course the question of whether the pattern we observe in the Netherlands can be seen elsewhere. This requires quite some further research, although one might intuitively expect to see the same pattern in countries where cooperative and savings banks have traditionally played a significant role, such as France and Germany, but also the United Kingdom, among others. Whether this is indeed the case requires further study.

*With thanks to the staff of the archive departments of ABN AMRO and ING and the National Archive for allowing us to consult the annual reports of the predecessors of the current major banks that are the subject of this study.

Annual reports 1900-1980:
Amsterdamsche Bank, Rotterdamsche Bank, Twentsche Bank, Nederlandsche Handel-Maatschappij, Algemene Bank Nederland, Amro Bank, ABN AMRO, Nederlandsche Middenstandsbank, Postcheque- en Girodienst, Coöperatieve Centrale Boerenleenbank, Coöperatieve Centrale Raiffeisenbank and Rabobank.

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