Regulation: Risk-weighting makes nonsense of leverage ratio

By:
Peter Lee
Published on:

Basel revisions dilute a key safeguard; bankers are celebrating.

You can’t please everyone. Banks have been arguing for months that holding them to a blunt leverage ratio, limiting the size of balance sheets irrespective of the high quality of large portions of their risk assets, might undermine their role as providers of funding to governments and corporations.

In January, the Basel Committee blinked and announced key amendments that will allow banks to reduce the notional size of their overall exposures through netting of repo transactions, recognition of cash margin protection, not double-counting exposure to central counterparties on cleared client trades and capping notional derivatives exposure at the maximum potential loss.

More controversially, it has recalibrated weightings against certain off-balance-sheet exposures such as revolving lines of credit away from 100% and in line with the standardized Basel approach subject to a 10% minimum.

It raises the question: if the leverage ratio is subject to such allowances does it still serve its intended purpose as a back-stop limit on banks piling on supposedly low-risk assets that eventually turn out to be anything but?

Analysts at Citi concluded, in a note published before Deutsche Bank’s early release of losses in the fourth quarter of 2013: "These steps signal significant regulatory forbearance and should alleviate some market concerns, notably for Barclays and Deutsche Bank."

Fitch notes that allowing some bilateral netting for repos and reverse repos might ease pressure on the banks and the market. The US tri-party market fell 14% in 2013, according to data from the Federal Reserve Bank of New York published last month, as interest rate rises and regulation influenced volumes. In Europe, despite its recent revival, the repo market is still below its June 2010 peak.

At Fitch, bank analysts felt moved to fire a quick warning shot over the new revisions to the leverage ratio. "If banks took on additional risks to take advantage of the revised rules, we would take this into account in our rating analysis," they said.

For many, this forbearance is good news and not only because of the nitty-gritty detail of allowances on the exposure measure, but also for signalling a pragmatic approach among bank regulators that they will not regulate the markets out of existence. FIG DCM bankers certainly welcomed it as they launched bond deals for banks in the first weeks of 2014.

"Recalibration of the leverage ratio is welcome news that compensates investors somewhat for concerns over bail-in that preceded it," says Sébastien Domanico, global head of financial institutions origination, debt capital markets, at Société Générale. "There has been so much confusion with so many new regulations coming all at once that it’s good to see regulators being pragmatic and not stringently imposing more pressure than the banks can bear," he says. "The leverage ratio has been a massive issue for many banks, so relaxing it a little bit is a positive."

Alberto Gallo, head of European macro credit research at RBS, is, however, distinctly unimpressed, calling the Basel Committee’s capitulation a bad move for financial stability in the medium term. He points out: "The leverage ratio prevents risk arbitrage from happening, by enforcing a minimum level of capital measured against an ‘exposure measure’ which approximates a bank’s total assets. This prevents banks from employing risk-weight-optimization to improve their capital – a practice that has been particularly successful around large banking groups. In practical terms, this means that several large eurozone banks optimized their assets to have risk-weighted assets down to 25% or even 20% of total."

He suggests that easing back on this measure now is the wrong response to ill-founded claims that over-regulation will impede lending. And while Gallo argues the Basel regulators might well want to revisit risk weights that have pushed banks to increase lending to sovereigns and reduce it to corporates, easing back on the leverage ratio is the wrong move at a time when banks still need more capital to operate safely.

"If another crisis were to occur, these banks could face losses much larger than the current minimum leverage ratio requirements are able to absorb," he says.