16th April 2014

Why leverage ratios are not as simple as they might seem

Written by Adam Cull, the BBA’s Senior Director (Financial Policy and Operations)

Last week, the US Federal Reserve announced that the largest US banks will be expected to meet a leverage ratio of 5 per cent. Their decision demonstrates once again how something intended as a simple and transparent backstop can be anything but.

A leverage ratio is simply a measure of a bank’s ability to absorb losses: a ratio of capital (the numerator) and exposure (denominator) expressed as a percentage. The regulatory response to the financial crisis has produced multiple ways of making this calculation.

Basel III introduces a leverage ratio as a complement to the existing risk-based capital framework used by regulators to monitor the solvency of banks by measuring capital against so-called ‘Risk Weighted Assets’. The Basel leverage requirement is set at 3 per cent (subject to possible further calibration) because it is intended to be a simple, non-risk based ‘backstop’ and not a binding constraint.

Rather than a single requirement for all institutions, US regulators have applied the minimum 3 per cent ratio but expect large bank holding companies to meet a 5 per cent requirement. This rises to 6 per cent for deposit taking subsidiaries that want to be considered ‘well capitalized’.

The situation is different in Europe. The Basel requirement will be implemented in the UK by the European Capital Requirements Regulation. As the European rule was agreed before the conclusion of the Basel process its currently subtly different to the Basel version.

The CRR requires European banks to disclose their leverage ratios from 2015 before the rule becomes a supervisory measure in 2018. In the meantime, a calibration exercise has been pencilled in to determine whether or not to increase the Basel requirement.

With markets watching on closely, banks have begun to disclose estimates of their leverage ratios under different versions of the rules.

This is true of UK banks. Their 2013 results reveal a multitude of ratios leading to a range of outcomes. For instance, there are CRDIV leverage ratios calculated on ‘transitional’ and ‘fully-loaded’ bases together with estimates of the ratio under both the Basel rules as proposed in 2010 and reviewed in January 2014. Such complexities are challenging for investors to understand.

Another issue is that there are some in Europe that think we should follow the Fed’s lead and apply US regulator’s logic to EU markets. However, there are some important differences in market structures and business models that need to be considered when comparing the US rules with the European framework.

US banks follow an originate to distribute model. This involves selling mortgages (assets) to state-backed underwriters thereby reducing the size of their balance sheets. European banks have traditionally retained mortgages on their balance sheets due to the absence of an established government backed MBS market and a relatively shallower base of institutional investors.

Ultimately, the US rules are tailored to this business model and not those of European institutions. Copying the US’ leverage ratio would therefore have a different impact if applied to European institutions.