A much overlooked sentence in the Leverage Ratio standard

While the Basel III Leverage Ratio standard has led to a suspicion by the financial press that the Basel Committee has been influenced by ‘ferocious industry lobbying’, a potentially impactful sentence has been overlooked by that same financial press.

According to the explanation on the BIS site, the leverage ratio framework is complementary to the risk-based capital framework. The simple, non-risk based ‘backstop’ measure will restrict the build-up of excessive leverage in the banking sector.

Basel Committee may implement a strict definition of capital

During the ‘parallel run’ period (from 1 January 2013 to 1 January 2017) the Basel Committee will use a minimum requirement for the leverage ratio of 3%. Ultimately it is up to the regulators to set the minimum required ratio.

Leverage ratios (Source: BIS, S.G. Cecchetti, Five years in the tower, June 2013)

Leverage ratios (Source: BIS, S.G. Cecchetti, Five years in the tower, June 2013)

So what is this much overlooked sentence? On page 2, paragraph 11, the Basel Committee states that:

The Committee will continue to collect data during the transition period to track the impact of using either Common Equity Tier 1 (CET1) or total regulatory capital as the capital measure for the leverage ratio.

If the numerator of the Leverage Ratio (the ‘capital measure’) is suddenly restricted to Common Equity Tier 1 capital only, this will have far-reaching implications for the ease with which the 3% minimum can be reached. Also, it will make hybrid capital such as contingent convertible debt unattractive.

Will the Basel Committee use the leeway that is created here? We cannot be sure, but an important clue can be gathered from the recent Basel standard on capital planning (January 2014, A sound capital planning process: fundamental elements):

In the absence of comprehensive information, some banks continued to pay dividends and repurchase common shares when capital could have been retained to insulate them against potential future losses. Some banks also issued large amounts of capital instruments – such as hybrid debt – that ultimately proved ill-equipped to absorb realised losses.

Impact

To sum up: the leverage ratio will not replace risk-weighted capital measures and it will continue to be used as a ‘backstop’. Its impact can be much more powerful than expected though, even within the 3% minimum requirement, if the Basel Committee will adopt a strict definition of the numerator. Also, regulatory compliance driven issuance of hybrid capital as Additional Tier 1 capital will be reduced to zero.

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Over Folpmers
Financial Risk Management consultant, manager van een FRM consulting department, bijzonder hoogleraar FRM

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