The Basel Committee issued changes January 12 to leverage-ratio requirements, a key part of Basel III guidelines that should lessen constraints on banks’ ability to provide financial products to corporate customers, although US rules based on those guidelines will likely be more burdensome when finalized.
The change lessens concerns that banks will have to reduce their activity in those markets or increase pricing. That may be particularly true for off-balance-sheet trade finance instruments, such as commercial letters of credit (LOCs), standby LOCs, acceptances and other types of unused commitments that companies engage in with their banks for trade purposes. Corporates’ derivatives in which banks act as counterparties would have also likely been impacted.
“The fact that [the Basel Committee] moved away from the 100 percent conversion factor for off-balance sheet instruments was very favorable,” said Alok Sinha, US banking and securities leader at Deloitte & Touche.
Now the Basel III guidelines allow the conversion factor to drop as low as 10 percent, an important change for banks providing LOC-type products, which typically appear as balance-sheet exposures only when they’re funded. Until then, banks earn only a few basis points in commitment fees, so if the capital ratio applied to the LOC is 8 percent, the 100 percent conversation factor would likely either prevent banks from engaging in the transactions or force them to raise prices dramatically.
“During the trade life cycle there are not high margins or fees that the bank gets. If the transaction is treated as funded at 100 percent, it would make it very expensive to earn any kind of return on that instrument,” Mr. Sinha said. If the conversion factor were instead the minimum 10 percent, the capital requirement would fall to 0.8 percent.
In addition to providing a more flexible conversion factor for off-balance sheet instruments, changes to the final Basel III standard include netting of securities-finance transactions and changes to the treatment of credit derivatives and exposures to central counterparties that will lower banks’ leverage ratios. To the same end, the final guidelines will now also allow the use of cash variation margin associated with derivative exposures.
“Right now banks engage in these transactions to a certain level, and with the leverage ratio potentially becoming blinding constraint, you could have had a situation where banks would do less of this business or charge more. So I think a lot of that pressure goes away,” Mr. Sinha said.
Luke Zubrod, director of risk and regulatory advisory at Chatham Financial, said the change does not ease concerns about the impact of US rules implementing Basel III on derivative pricing. “The particular rules (pertaining to counterparty credit risk) that had driven concern on derivatives pricing do not appear to be covered in this change,” Mr. Zubrod said, adding, “However, I gather that this [leverage ratio] change may ease concerns in certain narrow ways, including how capital charges will be applied to cleared trades, for example.”
In terms of the leverage-ratio change, a big unknown for banks subject to US regulations is how the Federal Deposit Insurance Corp.’s rule to implement the Basel III guidelines will pan out. Mr. Sinha noted that the FDIC issued a separate proposal for the leverage ratio, requiring a ratio a few percentage points higher than Basel’s 3 percent minimum.
“If you look at the harmonization of definitions, I can see the US adopting most of what’s in the international guidelines. But the actual level of the standard [US regulators] want to hold their banks to may vary,” Mr. Sinha said.