UK: Basel III: Proposed Revisions To The Leverage Ratio

Last Updated: 19 April 2016
Article by Azad Ali

The Basel Committee on Banking Supervision (the "Committee") has recently issued proposed revisions to the leverage ratio framework building on and amending standards issued in January 2014. It follows feedback from the industry on various aspects of the framework that were perceived not to sufficiently reflect the actual exposures or the allocation of risks associated with exposures. Particular issues concerned the treatment of initial margin collateral provided by cleared clients, limitations on exposure-reducing effects in derivatives trades of cash variation margin (CVM) provided in currencies other than the settlement currency and insufficient recognition of accounting provisions in terms of offsetting exposure values. There are additional clarifications on the treatment of credit derivatives and new rules specifically covering the treatment of "regular-way" purchases and sale of financial assets (typically cash products).

The proposals include some welcome changes and clarifications and acknowledgement of serious industry concern on certain markets such as repo, client clearing and market-making. Many market participants have already retrenched from certain businesses on account of increased capital requirements generated by the leverage ratio (as well as other elements of Basel III such as the liquidity coverage ratio and net stable funding ratio).

The comment period for the proposals expires on 6 July 2016. The Committee is also inviting banks to provide data on a number of issues including the impact of ignoring the exposure offset provided by client collateral on the cost and viability of client clearing business models, and the impact on balance sheets and on market making businesses between trade date and settlement date accounting in the context of the calculating exposure values to reflect settlement risks whilst delivery and payment legs of securities purchases remain unsettled.

Treatment of Derivative Exposures

Modified version of SA-CCR to be used to measure exposure value: Currently, exposure values of derivatives under the leverage ratio framework are measured using the Current Exposure Method (CEM). Both the CEM and the Standardised Method (SM), the two prescribed measures for measuring counterparty credit exposure values for derivatives under the risk capital framework, are to be replaced by the Standardised Method for measuring Counterparty Credit Risk (SA-CCR).

The CEM is based on calculating a replacement cost for a trade supplemented by an add-on to reflect potential future exposure (PFE). It does not distinguish between margined and unmargined trades, does not fully recognise the effect of netting, and the PFE add-on factors do not adequately reflect market volatility in recent periods. The SA-CCR is seen as a more risk-sensitive and improved basis for measuring counterparty risk than the either the CEM or SM. It takes account of trades that are collateralised as well as distinguishing between cleared and uncleared trades. The Committee has specified 1 January 2017 as being the date on which the SA-CCR is to be in force.

Given that one of the key aspects of the leverage ratio framework is to ignore any credit risk mitigation whether as result of collateral or otherwise, the Committee has opted for a modified version of the SA-CCR which would ignore collateral other than eligible CVM. However, the Committee is open to idea of accepting a wider range of CVM that does not, unlike currently, discount CVM on the basis it is posted in a different currency (see further below). In applying the SA-CCR, the PFE multiplier will be set to 1. The benefits of collateral will instead be recognised by way of a shorter margin period of risk (MPOR) ranging between 5 and 20 days depending on whether the trade is cleared and the size of the netting set.

Initial Margin (IM) posted by cleared clients: Notwithstanding vocal industry concern, the Committee proposes that collateral posted by cleared clients continue to be ignored when determining the PFE, but instead, the Committee suggests that collateral would be recognised through a shorter MPOR of 5 days provided there is daily variation margining. The Committee argues that a shorter MPOR results in a significant decrease in the PFE, which would not be substantially further decreased if IM were to directly offset the PFE under the SA-CCR. That said, the Committee is open to IM offsetting the PFE subject to being persuaded by the industry that this is necessary to preserve client clearing businesses and that such offset will nonetheless leave enough capital for banks to support their clearing activities.

Cash Variation Margin: Trades documented under a netting agreement may be subject to differing settlement currencies. In such a situation, net amounts, under margin calls for example, could be expressed in a single currency as specified in a CSA. Individual trades could of course be in a currency different from the termination currency specified in the netting agreement or from the currency of the collateral specified in the CSA. The Committee clarified in a October 2014 FAQ1 that "settlement currency" was wide enough to include any currency specified in the derivative contract, master netting agreement or CSA. Although no changes have been made in the proposed revisions, the Committee will continue to review the issue and suggests that CVM be subject to a FX haircut where the currency of the CVM does not match that the termination currency of the netting set. Further revisions may also be made to align the FX haircut with the treatment applied under the SA-CCR.

Credit derivatives: Under the current framework, the protection provider has to take the notional amount of the underlying as well as any counterparty credit exposure as the exposure value. This may be reduced by any negative fair value that has already been recognised in Tier 1 capital and by the notional amount under any credit derivative purchased on the same underlying. In relation to the latter offset, the Committee introduces new rules to address wrong-way risk where there is a correlation between the underlying and the counterparty from whom protection is purchased. Other proposed changes notably include the option of a partial reduction of the PFE where the effective notional is included with the exposure measure.

Treatment of Securities Financing Transactions (SFTs)

Where there is more than one SFT with the same counterparty, the net amount of cash payable and receivable across the SFTs can be used as the exposure value provided certain conditions are met. These include the need for the SFTs to have the same final settlement date. This excludes cash netting in open repos where there is no end date. The Committee acknowledges that open repos are functionally equivalent to overnight repos. Although no changes are proposed, further evidence is sought as to any adverse impact on the open repo market and whether further revisions may be warranted.

Traditional securitisations

The Committee is working on revisions to the treatment of exposures arising from traditional securitisations. In particular, the Committee is considering the case where the issuing SPV is required to be consolidated under accounting rules with the originating bank or the de-recognition of the underlying assets is not achieved under applicable accounting rules. In this situation, for risk capital purposes, the underlying assets would attract no credit risk capital on the basis either that the risk weight for such assets is 0% or they are excluded from the balance sheet altogether from a regulatory capital perspective. Under the former approach, the assets would still attract leverage capital as the leverage ratio calculation depends on the nominal value of assets irrespective of any risk weighting. The Committee will issue a clarification in due course taking into account its ongoing work on identifying and measuring step-in risk2.

Treatment of provisions

Currently, specific provisions can offset exposure values of non-derivative positions whilst general provisions do not reduce the exposure measure. Further, neither specific nor general provisions are recognised in reducing exposure values of off-balance sheet items. The Committee's proposals would now permit both general and specific provisions that have been accounted for in Tier 1 capital to reduce the exposure measure. This change is consistent with the current framework, which permits assets already accounted for in Tier 1 capital to be ignored in the exposure measure. Similarly, exposures from off-balance sheet items, after applying the relevant credit conversion factor (CCF), are also now to be reduced by provisions, both general and specific. A further adjustment to exposure values relates to prudent valuation adjustments for less liquid on-balance sheet positions.

Additional requirement for G-SIBs

The Committee is minded to increase the 3% leverage ratio minimum for G-SIBs. Several jurisdictions, such as the UK and US have already implemented stricter requirements. The Committee seeks views on whether there should be a cap on the amount of Additional Tier 1 capital that can satisfy any additional requirement, whether the calibration should be scaled to reflect the systemic footprint of a bank as is currently the case under the risk-based framework, and whether the additional requirement should be couched in terms of a higher minimum requirement or a buffer which, like buffers set in the risk capital framework, would operate to restrict capital distributions if breached.

Sales and purchases of financial assets

For sales in financial assets that give rise to settlement risk between the trade date and settlement date, purchasers are exposed to the risk in the change in value of purchased assets between the trade and settlement dates as well as to any asset that is the source of payment. Sellers are exposed to the risk of non-payment of the purchase price. Accounting frameworks are not harmonised as to trade date or settlement date accounting approaches which has led to differences between banks in the way settlement risks are reflected on their balance sheets and as a result their associated capital requirements. Settlement date accounting does not reflect the risks of non-delivery of purchased assets nor of non-payment of the purchase price.

A further issue relates to banks using trade date accounting for their market-making activities. Here, banks have been able to offset cash receivables from sales with cash payables from purchases and this has served to reduce volatility on the balance sheet from market-making activities. Recognising this, the Committee suggests two options, which would apply irrespective of the accounting treatment.

The first option, for banks using settlement date accounting, would require such banks to treat financial asset purchases as off-balance sheet items subject to a 100% CCF. For banks using trade date accounting, they would have to include gross cash receivables from sales without offsetting cash payables for unsettled purchases. For the latter banks, the second option, would, in addition, permit offsets of cash receivables and payables subject to certain conditions on which the Committee is seeking industry comment. These may include requirements that the trades are conducted by a market-maker, the relevant financial assets are being fair valued through income and included in the trading book, and that the trade is settled on a delivery-versus-payment basis. The Committee is also considering the conditions in which offsets could be permissible for settlement date accounting banks. Here the offsets would be between commitments to pay the purchase price for purchases and the cash receivable for sales. In this context, the Committee is also seeking views on the impact from disallowing offsets on market-making and market liquidity.

Off-balance sheet items – Credit Conversion Factors

The current framework relies on CCFs used in the risk capital framework for banks using the Basel II Standardised Approach to credit risk, subject to a floor of 10%. The Standardised Approach is being revised3, including in relation to the CCFs used to calculate credit exposure values for off-balance sheet items. Once finalised, these revised CCFs will be also be used to calculate exposure values for off-balance sheet items for the purposes of the leverage ratio. Current CCFs will apply in the interim period. For off-balance sheet securitisation exposures, CCFs were set out in the revised securitisation framework4 and these CCFs will apply for leverage ratio purposes from 1 January 2018.

Cash pooling

Where banks offer cash pooling to corporate clients, where the credit and debit balances of accounts of different entities within a corporate group are combined to yield a single balance, the Committee is proposing to only permit net exposure amounts to be used as the leverage exposure value only if there is physical pooling. This requires there to be a concentration account into which balances are physically transferred resulting in a single claim against a single entity within a corporate group. Physical transfers would have to be carried out on a daily basis. Notional pooling without physical transfers would have to be reflected in gross exposure values, consistent with the wider principle of ignoring credit risk mitigation and netting of assets and liabilities for the purposes of measuring leverage exposure.


1. See for the latest FAQ on the leverage ratio framework

2. See which addresses situations where a bank provides financial support to an entity in distress beyond any contractual obligation to do so. The consultation falls within the G20 initiative to strengthen the oversight of shadow banking.

3. See the Second Consultation on the Revisions to the Standardised Approach at:

4. Revisions to the Securitisation framework at:

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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