Regulation: The lobby for leverage

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Regulators seem to have the upper hand in the battle over bank leverage ratios.

The leverage ratio is a leading contender in the race to be the most controversial regulation in global banking. Analysts and policymakers are divided over the size, application and definition of the leverage benchmark, which might profoundly downsize international banks as well as adversely affect global commerce and the derivatives market.

The initial Basle proposal is for a 3% ratio – calculated by dividing an institution’s tier 1 capital by its total exposure – which will 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 Bank of England, has recently cast doubt on the efficacy of the risk-weighting of assets in Basle capital standards and, instead, called for a jump in the leverage quota as a more-effective non-risk-based prudential tool to buttress capital adequacy requirements.

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. The existing 4% US leverage ratio excludes off-balance-sheet exposures. By contrast, the Basle leverage-ratio proposal includes all exposures – a game-changer for US banks’ capital requirements, given the size of derivatives exposures, which are expressed as off-balance-sheet thanks to US accounting. It would also disproportionately hit European trade-oriented banks, such as HSBC and Standard Chartered, which have large contingent liabilities essential for trade financing, such as standby letters of credit as well as guarantees for performance bonds in project financing.

Bankers have been fiercely lobbying against the proposed calibration of the Basle ratio, aided by the lengthy transition period. Between January 2013 and 2017, the Basle leverage ratio will be non-binding and instead national regulatory standards will apply and from January 2015 banks will be required to disclose their leverage quota. However, recent banking scandals and anxiety over banks’ capital positions have ensured regulators now have the momentum. And on September 27, UK authorities tightened the screw by demanding that UK banks publish their leverage position from next year, amid howls of protest from bankers, fearing it will put them at a competitive disadvantage to their international peers.

A non-punitive conversion of off-balance-sheet items to their on-balance-sheet equivalents – a calculation known as the credit conversion factor – could reduce banks’ capitalization fears. However, for all the G20 summits and Basle meetings, it is unclear if 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 a flexible leverage-ratio requirement from Basle will emerge and national regulators will be able to exercise discretion in its application. How the Basle Committee strikes a balance between nurturing a level playing field for banks while permitting a degree of domestic differentiation will prove one of its most vexing of challenges.