Will Caps Being Considered For Bank Leverage Also Cap Returns?

The EU is looking at potential caps on the amount of leverage that banks can have on their balance sheets (see Financial Times article). What is unique, or at least of interest, is how there may be less differentiation between long-term investments and assets on shorter-term trading books. Charlie McCreevy, EU internal market commissioner, highlighted the need to considering both types of risk when he mentioned that "While the probability of default might be lower on a trading book because of the shorter time during which the assets are held, the impact of default when it happens is the same whether the asset has been held for a single day on the trading book or a whole decade on the banking book.” Commissioner McCreevy also did not hold his dislike for Value-at-Risk models, highlighting how VaR models are “very useful when they don’t matter and totally useless when they do matter”. This has certainly been a difficult year for VaR, but the question remains - What else do you use? Even if short-term trading book assets are given more attention, you still need to have an idea of your potential exposure and loss. Of course, maybe even more relevant is how the business models of some banks will need to change (either due to new regulation or pure survival needs), which will ultimately change the way such banks are valued going forward. While limits on leverage and risk may be good for the solvency of such banks, those that do survive will most likely continue to have their stock punished as investors try to get their hands around the valuation of new lower risk, and likely lower return, business models.