US regulators might surprise banks on supplementary leverage ratio

Peter Lee
Published on:

While banks now expect US regulators to follow Basel’s lead in relaxing the denominator of total assets, the Fed still worries about dealer dependence on short-term funding from SFTs and might demand a capital surcharge.

US bank regulators have scheduled a meeting for Tuesday to discuss possible amendments to the supplementary leverage ratio (SLR) for large US banks that was first proposed in July.

The regulators have come on tough with the country’s eight biggest banks on the leverage ratio, demanding they hold capital of between 5% at the holding company level and 6% at the insured operating division level against total assets.

Bankers hope and expect that US regulators will at least fall in line with the Basel Committee on Banking Supervision’s January decision to relax the definition of the exposure denominator. That would at least reduce the size of the assets against which banks will have to hold these high capital amounts and make it easier for them to meet the tougher US ratio.

International banks face a much lower Basel leverage ratio requirement of 3% capital against total assets.

In its January revision, the Basel Committee reduced the credit-conversion factor for certain off-balance-sheet commitments, such as short-term revolving credits, allowed for reduced counting of derivatives exposures where these are netted against cash margin, removed double counting of derivatives exposures cleared through central counterparties and allowed much greater netting of securities financing transactions (SFTs) where repo and securities lending transactions naturally offset.

This was a particular bugbear of banks lobbying against the leverage ratio who argued it might pose a threat to the efficient functioning of risk-free government bond markets. In aggregate, these new definitions of exposure were welcomed by the banks.

While many assume it likely that US regulators – including the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation – will now recalibrate their leverage ratio exposure definition to match the Basel Committee’s January revision and so promote greater regulatory harmonization, they might not be out of the woods yet.

Brian Smedley, US rates strategist at Bank of America Merrill Lynch (BAML), points out that in one aspect the US supplementary leverage definition of exposure already mirrors the revised Basel version: “The proposed US SLR had already assumed that banks would be able to net SFT exposures in accordance with US GAAP accounting practices.”

Could it possibly be that US regulators have a surprise in store? The Federal Reserve Bank of New York (NY Fed) recently published a series of 11 papers on large and complex banks, which are clearly intended to influence the debate on regulatory policy. One of these studies, Matching collateral supply and financing demands in dealer banks, has as one of its authors James McAndrews, head of research at NY Fed. It looks at how dealer banks capture a benefit by rehypothecating out collateral posted by one customer looking to borrow cash to another customer seeking to borrow a security to go short and posting cash back to the bank.

While a dealer’s balance sheet would show zero assets and liabilities from two such naturally offsetting positions, it has in fact provided substantial financing to two parties.

The study notes that US accounting rules allow dealer banks to provide funding for positions in excess of anything reflected on their balance sheets, even where these activities include maturity transformation and mis-matches and assumption of credit risk.

US regulators have long been conscious the failure of Lehman and its aftermath revealed a systemic frailty in the form of large dealer banks’ heavy dependence on this kind of short-term inventory financing that suddenly became much less available.

The authors note a disparity between how the risk of dealer financing is measured in banks’ collateral records compared with on their balance sheets and say the question of whether that risk is appropriately managed remains open.

They recommend: “Some capital and liquidity charge (as, for example, is the case with the liquidity coverage ratio [LCR]) for financing transactions that are currently subject to accounting netting treatment, and are therefore off-balance-sheet, does seem warranted.”

Daniel Tarullo,
member of the Fed's
board of governors
And in a speech in November on shadow banking and systemic risk regulation, Daniel Tarullo, member of the board of governors of the Federal Reserve, noted it as a failing that “the LCR does not require firms to hold any liquidity buffer against SFT liabilities that mature in more than 30 days or that are backed by very liquid assets”.

He added: “Moreover, the current regulatory framework does not impose any meaningful regulatory charge on the financial stability risks associated with SFT matched books.”

Noting the systemic risk of dealers suddenly pushed into fire sales of assets when the kind of repo and reverse repo short-term funding they have depended on in high volume during normal times suddenly disappears in a crisis, Tarullo then suggested one policy option might be to impose a regulatory charge calculated by reference to reliance on SFTs and other forms of short-term wholesale funding.

He talked of a weighting system for additional capital requirements to discriminate between the risks of different types of short-term funding with a capital requirement linked to the liability side of dealers’ balance sheets and so varying on their dependence.

So while US banks are hoping for good news on Tuesday, BAML’s Smedley points out: “While a less-binding SLR constraint would be positive for the US repo and Treasury markets, the Fed remains intent on curtailing the risks they see in short-term funding markets.

“Given these concerns, the Fed may propose a new Basel III capital surcharge in coming months that would be a function of banks’ usage of short-term wholesale funding. The Fed is also considering whether to introduce numerical haircut floors for SFTs.”