10 November 2010

Basel III Leverage Ratio – What Do Think about It?

In response to the recent financial crisis, Basel Committee on Banking Supervision (BCBS) is updating its capital adequacy framework, i.e. moving from Basel II to Basel III. One of the plans is the introduction of the so-called non-risk based leverage ratio the idea of which is to serve as a simple and credible backstop to the risk-based capital requirement. This ratio should be calculated as capital divided by total exposure, whereas according to the baseline proposal capital is meant to be high-quality capital and exposure the total exposure (on- and off-balance sheet) without any risk weighting but be measured consistently with financial accounts. More precisely, the Committee is proposing to test a minimum Tier 1 leverage ratio of 3% during the parallel run period from 1 January 2013 to 1 January 2017. Final adjustments into the principles of the proposed leverage ratio would be carried out in 2017 with a view to migrating to a Pillar 1 treatment on 1 January 2018 based on appropriate review and calibration.

When the idea of leverage ratio was first announced for commenting in December 2009, banks quickly came out with arguments and proposals such as:
  • Introduction of a leverage ratio would be an improper way to try to prevent possible future financial crises; at the same time it may have serious credit-squeezing effects and in particular provide an obstacle to the funding opportunities for low risk operations, such as loans to mortgage customers, the public sector and highly creditworthy companies;
  • The leverage ratio would hit low risk banks especially hard; it would also reduce the intensives to manage risks in a proper way;
  • It will increase the intensives to remove exposures from the balance sheet, for example trough securitisation (according to Swedish Bankers’ Association, the US financial market, which was long governed by capital regulations including a leverage ratio, is a clear example of this);
  • Leverage ratio should be institution-specific and take into account the specific business mix of an institution;
  • It should be combined with a “complain or explain” approach;
  • Even if the leverage ratio is introduced as a Pillar 2 and/or Pillar 3 (here it is referred to the three pillars of Basel II) measure, there is a risk that investors will see it as an important capital ratio; this would possibly lead to the above described consequences;
  • An inappropriately calibrated leverage ratio is likely to lead to additional risk taking by some institutions, while hurting those that run low risk operations;
  • Off-balance sheet exposures shouldn’t be subjected to 100 percent credit conversion factor; furthermore, off-balance sheet exposures with historically low risk profile [a long list of such exposures] should be exempted from the calculation of any leverage ratio;
  • Assets considered liquid assets under the liquidity proposal should not be subject to a leverage ratio; including these low-yielding assets in a leverage ratio would be a double impact on banks’ capital and earnings.

Read more banks’ responses from the homepage of Bank for International Settlements – that’s pretty interesting. These responses itself say one-comma-another.

Now the question: is holding 3% capital compared to the total exposure too much expected? Common sense at least suggests that no, not at all. But if still so and continuing to be strongly opposed by banks, reliability of banks’ risk-based capital adequacy calculations should be really questioned. To repeat once again, the idea of the leverage ratio is to serve as a simple and credible backstop to the risk-based capital requirement. Thus, by definition it should affect only a very limited number of banks with exceptionally low risk profile. Hard to believe that so many banks (implicitly) consider themselves as exceptionally-low-risk-profile banks.

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