UK: UK Leverage Ratio Requirement: A Cornucopia Of Capital Complexity?

Last Updated: 7 November 2014
Article by Simon Brennan and Kateryna Bobrova

Most Read Contributor in UK, August 2017

The Bank of England Financial Policy Committee's (FPC) recently published review on the role of the leverage ratio in the UK proposes moving ahead of international standards to introduce new requirements for the biggest UK banks and building societies from next year. It recommends those banks eventually meet a 'static' requirement of up to around 4% on an ongoing basis (comprising a minimum of 3% and a supplementary buffer capturing systemic risk). There would also be a time-varying component that varies with the credit cycle and could add around 90 basis points more for some banks at the top of the cycle (on the FPC's current assumptions).

Calibration, complexity and risk-sensitivity were important topics of debate in advance of the report. The fixed part of the requirement came out close to most industry expectations, although considerably lower than some. The overall package is simpler than in the previous consultation, although it remains more complex than some would have liked. The FPC highlighted that 3% leverage is consistent with the minimum Tier 1 risk-weighted capital required against mortgage lending under the Basel Standardised Approach, so as not to disincentivise banks and building societies from (new) mortgage lending.

The government will now lay legislation before Parliament to effect the recommendations (giving the FPC the power to direct the Prudential Regulation Authority (PRA)). Once approved, the minimum requirement of 3% will be applied straightaway for the largest banks and building societies (superseding the current supervisory expectation that these firms meet a 3% minimum). Buffers within the ratio will be implemented subsequently. Other PRA-regulated firms will be required to meet the 3% minimum from 2018.

UK leverage ratio: simples

The complexity of the proposed leverage ratio framework is borne out of symmetry with the risk-weighted framework, which the FPC argues is required to maintain the relationship with the risk-weighted ratio (and therefore its effectiveness). The ratio will comprise:

  • A minimum requirement of 3%, for all PRA-regulated firms.
  • A supplementary leverage ratio buffer (SLRB) for UK G-SIBs, ring-fenced banks and large building societies. The G-SIBs buffer will be set at 35% of the risk-weighted systemic risk buffer and will be phased in from 2016. The appropriate calibration of the buffer for the other firms will be reviewed next year and will apply from 2019.
  • A countercyclical leverage ratio buffer (CCLB) that varies with the (macro prudential) countercyclical capital buffer (CCB). The FPC expects to set the CCLB at 35% of the CCB. The CCLB will apply to all PRA-regulated firms, as the CCB does, and will be introduced at the same time as the minimum requirement.

The requirements will initially apply at a consolidated level. The FPC will review in 2017 whether the requirements should be extended to apply at the solo level.

Banks will need to meet the requirements using a minimum amount of Core Equity Tier 1 (CET1) capital (at least 75 per cent) for the baseline requirement. All leverage ratio buffers should be met using CET1 exclusively. The Chancellor has asked for this to be aligned with international standards, when they are reviewed – in particular the eligibility of AT1 instruments.

The FPC says that in future it expects the PRA to consider the leverage ratio when determining the regulatory response to stress testing. It does not though give an indication of a minimum requirement for the leverage ratio under stress scenarios.

What it all means

While the new framework provides an important missing piece of the capital jigsaw, the picture is by no means complete. The Financial Stability Board's (FSB) proposals for Total Loss Absorbing Capacity are due early this month, and the Bank of England will consult on the "PRA buffer" in January 2015. In addition, both the Basel Committee and the EU Commission are due to review aspects of the leverage ratio in coming years, and further changes may follow. So it will still be some time before the overall capital requirements for the major UK banks are fully specified and an assessment can be made of their aggregate impact.

Looking to implementation, an increasingly important challenge for banks will be managing capital planning and business model decisions within a capital framework that considers simultaneously a risk-weighted capital ratio, leverage ratio, stress testing and loss absorbing capacity requirement. The leverage ratio also interacts with other prudential measures, such as the liquidity coverage requirements

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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