The next regulatory battle: the leverage ratio

By:
Sid Verma
Published on:

The battle to shape Basel's leverage ratio - the last capital pillar of banking reform - has kicked off, with potentially profound consequences for global institutions.

Sheila Bair, former chairperson of the Federal Deposit Insurance Corporation (FDIC), clearly has no desire to become US Treasury secretary in any second Obama administration. In a sensational book to be published later this year, Bair blasts Tim Geithner in marginalizing her in the 2010 Basel III negotiations and spearheading a push to water down capitalization proposals. 

 former Federal Deposit Insurance Corporation chair Sheila Bair, who now heads the Systemic Risk Council
Former Federal Deposit Insurance Corporation chair Sheila Bair, who now heads the Systemic Risk Council 
Geithner allegedly lobbied for a 6% minimum common equity capital ratio while Bair called for 10%, including a capital conservation buffer. Bair found her allies in Mervyn King, Bank of England (BoE) governor, Adair Turner, the UK’s Financial Services Authority chairman, and Philipp Hildebrand, the former governor of the Swiss National Bank. In the end, Basel opted for a 7% ratio, triggering the UK and Swiss authorities to enact higher capital standards.

But rather than penning a book to settle scores with Geithner, Bair should spill the beans on one of the most interesting of battles – the leverage ratio, a non-risk based prudential tool to complement minimum capital adequacy requirements. She herself has recently called for a "hard-and-fast" leverage ratio of 8%. This ratio, in addition to divergent risk-weighted asset calculations and accounting norms, throws into sharp relief intra-European and transatlantic divisions, with policymakers divided over the size, application and definition of the benchmark.

The initial Basel proposal is for a 3% ratio to be negotiated in the coming years before a binding requirement kicks in by 2018. The battle has already begun. Andrew Haldane, executive director for financial stability at the BoE, and Thomas Hoenig, a board member of the FDIC, have recently cast doubt on the efficacy of the risk-weighting of assets in Basel capital standards and, instead, have called for a jump in the non-risk-based leverage quota.

Privately, bankers express support for the philosophical and operational thrust of such a proposal: a reduction in risk-weighting reduces the complexity of regulation and potential for unintended consequences. However, bankers should be careful what they wish for.

While the 4% US leverage ratio applies on a consolidated basis, at the level of the bank holding company, as well as at the level of individual banks, significantly it does not take into account off-balance-sheet exposures. (In reality, market pressures, including corrective-action rules in banks’ financing products, mean the leverage ratio is 5% minimum – not including off-balance-sheet liabilities.)

By contrast, the Basel leverage-ratio proposal includes all exposures, a game-changer for US banks’ capital requirements, given the size of derivatives exposures, which are expressed off-balance sheet thanks to US accounting norms.

At the other extreme is the Canadian assets-to-capital multiple, which is a more comprehensive leverage ratio because it also measures economic leverage, to some extent, and off-balance-sheet liabilities – a key factor in mitigating Canadian systemic risk, along with sound supervision and conservative lending practices.

Bankers have been fiercely lobbying against the proposed calibration of the Basel ratio, aided by the lengthy transition period. Between January 2013 and 2017, the Basel leverage ratio will be non-binding and instead national regulatory standards will apply.

Lengthy timetable
From January 2015, banks will be required to disclose their leverage ratio, and by the first half of 2017 final adjustments will be enacted before it becomes a binding requirement under Pillar 1 of Basel III. By end-October 2016, the European Banking Authority will report to the European Commission on whether the 3% proposal will be sufficient, and whether it should apply for all the institutions, or differ by type.

However, recent banking scandals and public anxiety over banks’ capital positions have ensured regulators now have the momentum. And on Thursday, UK authorities tightened the screw by demanding UK banks publish their leverage position from next year, amid howls of protest from bankers, fearing a competitive disadvantage over their international peers.

Some analysts are sounding the alarm. The Basel proposal is "draconian" since it encompasses off-balance-sheet contingent liabilities essential for trade financing, such as guarantees for performance bonds in project financing and stand-by letters of credit, says Hank Calenti, head of UK bank credit research at Société Générale. As a result, the Basel proposal would disproportionately hit trade-orientated UK banks, such as HSBC and Standard Chartered, he says, while penalizing US banks for large derivatives exposures. Nevertheless, a non-punitive conversion of such off-balance sheet items to their on-balance sheet equivalents - a calculation known as the credit conversion factor - could reduce banks' capitalization fears.

At the heart of Basel’s regulatory philosophy is a desire to curb two of the biggest types of leverage risk, analysts say: balance sheet and economic. While balance sheet leverage has been mitigated by traditional core capital requirements, the correlation and linkages of financial markets amid market and economic shocks highlight how banks are exposed to so-called economic leverage.

Examples of this vary but include realizing loan guarantees amid natural disasters, to off-balance-sheet repo-to-maturity plays going awry during the eurozone debt crisis, as in the MF Global saga.

However, for all the G20 summits and Basel meetings, it is unclear whether a consensus can be forged on the size, definition and consistency of application of the leverage ratio, given a lack of agreement on calculating its components – banks’ capital and exposures – and the potentially enormous systemic impact on financial markets.

As a result, in practice, bankers hope in the coming years a highly vague leverage-ratio proposal from Basel will emerge and national regulators will be able to exercise discretion.

There is one risk in this approach: financial protectionism. When Swiss regulators introduced a leverage ratio for UBS and Credit Suisse in 2010, it explicitly excluded the banks’ Swiss loan books from asset calculations in order to reduce deleveraging risks.

However, there is a silver lining in the lack of global consensus: amid fears that international regulators are straitjacketing the financial system in a one-size-fits-all fashion, divergent prudential capital measures might help to breed some diversity.