By Dwight Cass
Basel III’s leverage ratio now constrains derivatives and off-balance-sheet activities much less than initially proposed.
Several years of lobbying by banks and their supporters paid off in January when the Basel Committee announced changes to the calculation of the bank leverage ratio that make the measure less onerous to banks involved in capital markets, derivatives and off-balance-sheet activities.
Big US banks joined with European institutions scrambling to raise capital to lobby regulators for a less effective leverage limit. They argued that the additional capital the banking industry would need to meet the leverage ratio published last year would cut the amount of credit available to businesses and consumers.
Originally the 3 percent leverage ratio calculation lumped together most assets to which banks had exposure. The modified calculation is more complex, and allows banks to avoid lumping in most off-balance-sheet exposures. (See BIS announcement here.) For example, banks only need to account for 10 percent of assets such as letters of credit. Derivatives and repo arrangements conducted with the same counterparty can be netted out, significantly reducing the amount of capital required under the Basel III leverage provision.
Banks criticized the leverage ratio for being too “blunt” a tool, even though at 3 percent it would be swept away in the first days of a 2008-style financial crisis. Even so, it was meant to back-stop the risk-based capital calculations that banks arbitraged and muddled in the run-up to the financial crisis with an absolute minimum level of equity to total assets. Giving banks the ability to noodle around with the calculation of total assets means that the leverage ratio is now more or less another calculation that banks can tweak as they see fit.
Banks complained about the leverage ratio’s effect on credit availability. But it’s not the lending institutions that benefit most from the changes. Rather it is securities and derivatives broker-dealers. As originally proposed, these firms would have had to include all their off-balance-sheet exposures, including securities, derivatives, guarantees and even letters of credit.
For trading houses, the change is particularly beneficial. These firms can now net securities financing transactions and can avoid double counting transactions with central counterparties.
More Credit Due?
It remains to be seen whether banks will be able to offer derivatives or other off-balance-sheet products to corporate hedgers and other institutions more cheaply than they would have otherwise. The prospect of more expensive hedging and credit was one of the threats the industry’s lobbying arms used to attempt to convince regulators that the leverage ratio needed to be weakened. A similar set of arguments were deployed against Basel III’s liquidity requirements, which now allow all types of assets to be counted as “liquid,” including equities.
It remains to be seen whether banks will be able to offer derivatives or other off-balance-sheet products to corporate hedgers and other institutions more cheaply than they would have otherwise.
There are few examples of banks passing on savings to customers from regulatory reprieves, despite their propensity to pass on regulatory costs.
In terms of off-balance-sheet items, specifically derivatives, interest rate products receive the most favorable treatment. (See chart.) Banks will be unable to use the leverage ratio as an excuse for higher prices on swaps and similar instruments. However, commodities other than precious metals have a higher “add on” in the calculation of assets, and this could have some effect on their cost.
The BIS also issued its guidelines for liquidity ratio disclosures in January. The point of the liquidity coverage ratio (LCR) is to ensure a bank has enough high quality liquid assets (HQLA) to survive a “significant stress” lasting for 30 days. The related regulatory tool is the Net Stable Funding Ratio (NSFR) which is meant to reduce bank funding risk by ensuring each institution funds its activities with “sufficiently stable sources of funding.”
The Ratio’s Rationale
According to the BIS’s June 2013 proposal, the leverage ratio is intended to:
- restrict the build-up of leverage in the banking sector to avoid destabilizing deleveraging processes that can damage the broader financial system and the economy; and
- reinforce the risk-based requirements with a simple, non-risk-based “dri” measure.
The rationale for the ratio was:
- a simple leverage ratio framework is critical and complementary to the risk-based capital framework; and
- a credible leverage ratio is one that ensures broad and adequate capture of both the on- and off-balance sheet sources of banks’ leverage.
The LCR will kick off on January 1, 2015, with a minimum requirement of 60 percent. That will increase in annual steps to reach 100 percent in 2019. However, the BIS says that banks can use their stocks of HQLA during times of significant stress to weather those periods even if that means their LCR falls below the minimum as a result.
All internationally active banks will be required to disclose their liquidity position at the same time as they report their other financials. The reports will be made on a consolidated basis but individual countries’ regulators can tweak their specific requirements to ensure that the disclosures are adequate to the market and to keep a level playing field.