13th July 2016

How can banks capitalise on the Leverage Ratio?

Written by Simon Hills, Executive Director, Prudential Regulation and Risk

Last week I submitted the BBA’s response to the Basel Committee on Banking Supervision’s (BCBS) recent consultation on the Leverage Ratio.

The Leverage Ratio was first introduced in the US in 1981, well before the global financial crisis. Following the finalisation of the BCBS’s Basel III Leverage Ratio framework in January 2014 it will become a metric that is applicable to all internationally active banks from the beginning of 2018. A number of countries, including the UK and Switzerland have already introduced requirements. Europe, which currently requires banks to disclose their Leverage Ratio to their supervisor, is currently considering how to introduce it as a hard requirement, perhaps via amendments to the Capital Requirements Directive expected by the end of the year.

The Leverage Ratio is designed to be a simple, accountancy-standard neutral, non-risk based complement to the much improved risk weighted minimum capital adequacy framework. In the BBA’s view, this framework should remain the most appropriate way of ensuring that banks hold sufficient capital against the risks to which they are exposed.

It is the ratio of a bank’s tier 1 capital to its total assets – broadly speaking its loans – plus off-balance sheet exposures, such as trade finance of derivative transactions.

Leverage Ratio = Capital/Exposures

A lower Leverage Ratio indicates that the bank is more reliant on debt to fund its assets and has a smaller capital cushion in the event of any defaults on its loans.

As well as emphasising the primacy of risk weighted capital ratios as a key metric in the regulation of banks we reminded the BCBS in our response that there are many other initiatives that seek to improve bank regulation so that no bank is ever  again ‘too-big-to-fail’. So the role of the Leverage Ratio needs to be considered holistically in conjunction with all these other measures and particularly to ensure that the Committee’s objective that there should be no significant increase in capital across the banking system is met.

On a more technical level we supported the BCBS proposals that credit conversion factors for off balance sheet items should be aligned with those in the risk adjusted framework for the capital adequacy calculation. We did, however, oppose to the new requirement that a 100% credit conversion factor is applied to the posting of securities as collateral which we believe is unnecessarily punitive, and risks double counting of exposure.

We also supported the BCBS’s introduction of the new standardised approach for counterparty credit risk (SA-CRR) but did not agree with the proposed departures from SA-CRR framework for Leverage Ratio purposes. We believe that neither the collateral, nor the netting achieved under normal derivative contractual practice is properly recognised in the Leverage Ratio proposals.

We were pleased that the BCBS has recognised in its proposals that the treatment of security settlement balances within the Leverage Ratio differs because of the varying accounting frameworks across the globe. This means that banks using trade date accounting under IFRS will record significantly higher balances than US banks operating under the unsettled regular way trade US GAAP accounting treatment.

Finally our response addressed alternatives to the application of higher Leverage Ratio buffers to the largest, most globally significant banks and were of the opinion that any additional Leverage Ratio requirements should be designed to be independent of a bank’s risk weighted position and that the size of any additional Leverage Ratio buffer requirement above the 3% minimum should be derived following an independent calibration, resulting from a quantitative impact study and stress testing exercises.

The BCBS’s Leverage Ratio consultation is the last significant piece in jigsaw that the it will be taking into account as it finalises the calibration of the overall revised regulatory architecture by year end. But it is complex jigsaw with many and differently shaped interlocking pieces. Banks are keen to understand what the completed picture looks like but do not want to rush the task of forcing a tabs into blanks that do not quite fit. The BCBS should take its time to ensure the whole suite of changes is capital neutral. Not to do so risks impairing banks’ ability to undertake their basic role in society of taking deposits and making loans.

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