United States: Basel III Framework: The Leverage Ratio

Reducing excess "leverage" in the banking sector is a key component of the Basel III capital standards. "Leverage" for these purposes means the ratio between a bank's non-risk-weighted assets and its capital. The ratio is intended to be a hard backstop against the risk-based capital requirements and is also designed to constrain excess leverage, which was common amongst many banks pre-crisis. Banks will be required to hold Tier 1 capital of at least 3% of their non-risk weighted assets but some of the stricter elements of the 2013 proposal have been relaxed.

When the Basel Committee on Banking Supervision (the "Basel Committee") published its consultative document Revised Basel III Leverage Ratio Framework and Disclosure Requirements in June 2013 (the "2013 Consultation"), it was met with substantial opposition, particularly from banks involved in the securities and derivatives markets. Most significantly, the 2013 Consultation did not permit the netting of securities finance transactions and did not allow collateral to reduce derivatives exposures. Some banks feared having to raise billions in extra capital to meet the proposed leverage limit. Having carried out a study of bank data to analyze the potential impact of the proposed reforms, the Basel Committee published an amended full text of the Basel III Leverage Ratio Framework and Disclosure Requirements on 12 January 2014 (the "2014 Revision"), which considerably modified the leverage ratio's exposure measure.

The Leverage Ratio

The leverage ratio is a separate, additional requirement from the binding Basel risk-based capital requirements, so is a supplemental non-risk-based "back-stop." It is defined as the capital measure (the numerator) divided by the exposure measure (the denominator). The capital measure is made up of Basel III Tier 1 capital. The minimum leverage ratio is currently set at 3%.

Thus the method of calculating the leverage ratio is:

The Basel Committee has indicated that it will continue to collect data during the leverage ratio's observation period (i.e. until 1 January 2017) to assess both the appropriateness of a minimum Tier 1 level at 3% over a full credit cycle and for different types of business models, and the impact of using Common Equity Tier 1 or total regulatory capital (Tier 1 +Tier 2) as the capital measure.

The leverage ratio defines exposures (the denominator) as the total of a bank's:

  1. on-balance sheet assets, including on-balance sheet collateral for derivatives and securities finance transactions not included in items (ii)-(iii) below;
  2. derivative exposures, comprising underlying derivative contracts and counterparty credit risk ("CCR") exposures;
  3. securities finance transactions ("SFTs"), including repurchase agreements, reverse repurchase agreements and margin lending transactions; and
  4. other off-balance sheet exposures, such as commitments (including liquidity facilities), guarantees, direct credit substitutes and standby letters of credit.

The specific treatment of each of these types of exposure is set out in the summary table at the end of this client publication.

The exposure measure under the 2013 Consultation did not generally permit recognition of the exposure-reducing effects of any credit risk mitigation techniques (for example, through guarantees, credit default swaps, collateral or netting of loans and deposits). The 2014 Revision made some concessions in this regard, for example, allowing cash variation margin to reduce exposures when certain conditions are met.

Criticisms of the 2013 Consultation

The main criticism of the 2013 Consultation was that its measures were over-zealous to the extent that they increased the leverage ratio significantly beyond actual economic exposures. The imposition of a considerably larger exposure measure as the denominator would result in the leverage ratio, rather than the Basel III risk-based capital measure, becoming effectively the only minimum capital requirement for a significant number of banks. The 2013 Consultation therefore attracted a fair amount of critique,1 including the following:

Incentives to Hold a Higher Proportion of Riskier Assets. Equating low-risk assets with riskier assets which produce a higher relative return than safer, low-risk assets, but also carry risk of higher exposure could discourage banks from holding assets such as cash and government securities. This may, in turn, negatively impact the liquidity of markets for government debt and monetary policy regimes which are dependent on SFT markets.

Tension with the Liquidity Coverage Ratio ("LCR"). Given that the LCR encourages banks to hold cash and sovereign debt as part of a liquid assets buffer, there is a tension with compliance with the LCR. This criticism would be most relevant to those banks who would find the leverage ratio a greater hurdle to overcome compared to the risk-based capital requirements.

Overstating Actual Economic Exposure ("Double Counting"). Actual economic exposures would be overstated by disregarding the exposure-reducing benefits of cash collateral in derivatives transactions and lead to "double counting" of transaction leverage. As a result, banks may be tempted to accept non-cash collateral, contrary to prudent risk management strategies. Derivative contracts cleared through CCPs would have been particularly affected because of the potential exposures on both the CCP and client legs of the transactions. High capital costs on margin requirements could have rendered client clearing very expensive for clearing members and end-users, an outcome that is inconsistent with the G20 mandate to ensure central clearing of OTC derivatives. In addition, the prohibition on netting and other adjustments for SFTs and credit default swap exposures proposed in the 2013 Consultation could result in a higher exposure measure for those transactions than the maximum amount of loss that such exposure could cause the bank.

The 2014 Revision

The 2014 Revision introduced significant amendments to the 2013 Consultation in order to address the criticisms voiced by industry participants. The key aspects of the 2014 Revision are set out below.

  • Cash Variation Margin. Cash variation margin is now permitted to reduce the mark-to-market exposure of derivatives. This is a welcome development from an industry perspective and consistent with the generally accepted industry view that exposures should be reduced by cash, which is relatively risk-free. However, this accommodation has been blunted somewhat as cash collateral is required to be in the same currency of the underlying trade which is problematic given the multi-currency relationships clients have with their dealers or prime brokers. It is possible that exchange rate risk could have been addressed through haircuts being applied to cash collateral given in a different currency. Further, it is unclear how the amendments will affect the ISDA Standard Credit Support Annex ("SCSA") for collateralizing over-the-counter ("OTC") derivatives contracts, published in June 2013. The SCSA was published by ISDA to ensure its credit support documentation adequately reflects the global drive towards clearing OTC derivatives and to reduce valuation disputes that have arisen within multi-currency CSAs. However, the restriction to same-currency variation margin may require the SCSA to be reformulated.
  • Client Cleared Exposures. Client cleared exposures are now excluded from the exposure measure for centrally cleared derivatives, which reduces the "double counting" of trade exposures and makes being a clearing member of a central counterparty more economically attractive. This is a logical clarification and is consistent with the shift to central clearing of OTC derivatives and the EU Capital Requirements Regulation (Article 306) which does not count such exposures as introducing credit risk.
  • SFTs. Provided the transaction is with the same counterparty, limited netting of cash payables and receivables in SFTs is now permitted where the SFT has the same final settlement date, the counterparties intend to settle simultaneously and the right to set-off is available. However, it should be noted that collateral itself is also included in the exposure measure given the fear that on-balance sheet collateral can be used to leverage a bank further. Accordingly, the impact of this modification on the leverage calculation may be lower than originally anticipated.
  • Credit Derivatives. Credit derivatives create a notional credit exposure arising from the creditworthiness of the reference entity and therefore the effective notional amount of the credit derivative is included in the exposure measure in addition to the CCR exposure amount for derivatives and related collateral. The 2014 Revision now provides for the notional exposure measure to be capped at the level of the maximum potential loss, and there is some broadening of eligible offsetting hedges in the calculation methodology.
  • Off-balance Sheet Items. The 2013 Consultation was more stringent towards off-balance sheet items by prescribing that firms could use a 100% credit conversion factor ("CCF"), unless the commitment was unconditionally cancellable at any time by the bank without prior notice, in which case the CCF would be 10%. The 2014 revision now takes a more nuanced approach to off-balance sheet exposures by using the Basel II framework's CCFs so that the CCF is not fixed at 100%. For example, letters of credit now have a 50% CCF.

Consequences of the 2014 Revision

The revised framework significantly eases the leverage ratio requirements for certain exposures, such as derivatives and repurchase agreements which make up a significant proportion of banks' balance sheets. It is perceived that the loosening of the requirements will enable larger banks to meet the ratio, whereas under the previous formulation, it was suggested that as many as three-quarters of Europe's largest banks may have failed the test.2 Repo activity is now less likely to be affected after the 2014 Revision, particularly as the effect of netting of positions is now recognized. Furthermore, for off-balance sheet exposures, the use of the CCF exposure categories in the Basel risk-based capital framework rather than a blunt 100 % requirement better reflects the reality that certain off-balance sheet items, for example, certain trade, export and project finance commitments (as opposed to drawn loans), are unlikely to convert to on-balance sheet exposures in many instances.

The modifications introduced by the 2014 Revision therefore appear to better align the leverage ratio to real risk exposures and reduce banks' incentives to shun cash and other high quality liquid assets. However, the 2014 Revision does not go as far as some banks would have liked, particularly as banks will still have to hold capital against safe assets that form part of their liquidity buffers. It remains to be seen whether the 2014 Revision has reached an optimum middle ground by reducing banks' balance sheets enough to counteract the harmful effects of "double counting" exposures, while ensuring that the leverage ratio remains an effective measure of comparison and a meaningful supplement to the risk-based capital framework.

Implementation of the Leverage Ratio

Implementation of the leverage ratio obligations began on 1 January 2013 with bank-level reporting to national supervisors of the leverage ratio and its components. Public disclosure will be required from 1 January 2015. The, ratio, is still under review by the Basel Committee. It is expected that any final adjustments to the definition of the leverage ratio will be completed by 2017 with a view to migration to a Pillar 1 (minimum capital requirement) treatment on 1 January 2018. Moreover, national legislation is required to enact these new rules. The 2014 Revision is therefore still vulnerable to change and will likely be subject to a couple of years' more scrutiny as the parameters of the ratio are worked out and adapted locally.

EU Position

Despite the 2014 Revision's strong commitment to the leverage ratio's efficacy, the EU has faltered in its support for the leverage ratio as a Pillar I measure and has instead adopted it as a Pillar II measure (i.e., the national regulator will determine whether or not the leverage ratio of a particular institution is too high and whether the institution should hold more capital as a consequence). The European Commission's (the "Commission") frequently asked questions, published on 21 March 2013, indicate that an assessment of the leverage ratio is still underway, in particular as regards whether the leverage ratio should be introduced as a binding measure at all. Furthermore, the EU has already loosened the Basel Committee treatment of trade finance under the leverage ratio by applying lower conversion factors to trade-related off-balance sheet items under the Capital Requirements Regulation. The Commission also notes that "several levels of the leverage ratio may be introduced in order to reflect the overall risk profile, the business model, and size of the institution". Despite the EU's general reluctance to commit to a binding leverage ratio at the moment, varying national standards across the EU have already been implemented. The UK has introduced a national binding 3% leverage ratio requirement on its largest banks, although the Bank of England has stated that this percentage may change depending on the final Basel III measure.

US Position

The US is moving towards a more stringent approach to leverage by the introduction of certain "super-equivalent measures," which subject banks to tougher requirements than those in the Basel III leverage ratio. In the US, "advanced approaches" banks3 will be required to comply with the current Basel III leverage ratio standards (3%), as well as the existing US Tier 1 capital-to-assets leverage ratio (generally 4%). Furthermore, the Federal Reserve, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency have, separately from Basel III, proposed an "enhanced supplementary leverage ratio" for the largest banking organisations. Under this proposal, covered bank holding companies would be required to maintain a supplementary Basel III-based leverage ratio of at least 5% which, if not met, would require restrictions on capital distributions and discretionary bonus payments. In addition, insured depository institution subsidiaries of those covered bank holding companies would be required to maintain a leverage ratio of 6% in order to be considered "well capitalized" under the applicable prompt corrective action framework. The leverage ratio proposals constitute another effort by US supervisors to impose strong prudential requirements on systemically important financial institutions and are intended to operate in addition to the proposed US regulation on the liquidity coverage ratio which aims to impose quantitative requirements on major US banks' liquidity management practices.4 This enhanced supplementary leverage ratio would make the US version of Basel III much stricter for large US banks than their European competitors and could present a competitive disadvantage to US banks. Nevertheless, US regulators will be lobbied to reduce the US requirements or introduce similar relaxations to the US rules as are set out in the Basel III standards. Further, many European member states may opt for a leverage ratio that higher than-Basel III, which could help to even out competitive disadvantages currently faced by US banks.

Conclusion

The leverage ratio has been criticized as a crude and antiquated measure of bank capital adequacy in comparison with the risk-weighted model, particularly as it makes no distinction between economically significant risk exposures, low risk assets which are a necessary component of other Basel standards and certain off-balance sheet items, which pose little actual economic risk. Regulators, however, maintain that the leverage ratio is still a valuable tool in assessing the strength of banks as it cuts across discrepancies in banks' own internal modeling as to the perceived riskiness of assets. The full extent of the 2014 Revision amendments is difficult to gauge at this stage, although it is anticipated that most big European banks will now pass the minimum 3% test. The debate surrounding the leverage ratio is not over yet. The 2014 Revision has provided us with a common definition of the ratio, but we will have to wait until 2017-18 to see how high and in what way it will ultimately be set in different countries.

To read this article in full, please click here.

Footnotes

1 Most notably, see the responses to the 2013 Consultation by the Global Financial Markets Association, American Bankers Association, Financial Services Roundtable, Institute of International Bankers, Institute of International Finance and the International Swaps and Derivatives Association, who represent the largest participants in national and global banking and financial markets, dated 20 September 2013.

2 See the Basel III Leverage Ratio Survey published on 20 September 2013 by The Clearing House, GFMA, AFME, ASIFMA & SIFMA.

3 US banking groups with consolidated assets of at least $250 billion or consolidated total on-balance sheet foreign exposures of at least $10 billion.

4 The text is available on the Federal Reserve's website at http://www.federalreserve.gov/aboutthefed/boardmeetings/20131024openmaterials.htm. When adopted, this will be Federal Reserve Regulation WW. If you wish to obtain more information on these proposals, you may review our client memorandum "Dodd-Frank: The Liquidity Proposal is Issued" (25 October 2013).

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Barnabas W.B. Reynolds
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration
Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:
  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.
  • Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.
    If you do not want us to provide your name and email address you may opt out by clicking here
    If you do not wish to receive any future announcements of products and services offered by Mondaq you may opt out by clicking here

    Terms & Conditions and Privacy Statement

    Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

    Use of www.mondaq.com

    You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

    Disclaimer

    Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

    The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

    Registration

    Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

    • To allow you to personalize the Mondaq websites you are visiting.
    • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
    • To produce demographic feedback for our information providers who provide information free for your use.

    Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

    Information Collection and Use

    We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

    We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

    Mondaq News Alerts

    In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

    Cookies

    A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

    Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

    Log Files

    We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

    Links

    This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

    Surveys & Contests

    From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

    Mail-A-Friend

    If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

    Emails

    From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

    *** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .

    Security

    This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

    Correcting/Updating Personal Information

    If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

    Notification of Changes

    If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

    How to contact Mondaq

    You can contact us with comments or queries at enquiries@mondaq.com.

    If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.

    By clicking Register you state you have read and agree to our Terms and Conditions