Imagine
you have a sore throat. You ask your doctor to have a look. He
prescribes you a standard medicine and sends you back home. A week
later, it’s not only your throat that hurts. You also suffer from
earache and fever. How is that possible? You simply haven’t told
your doctor that you were in bad physical shape and felt ill since a
long time. If he had examined your whole body, he would had perhaps
have detected your additional health problems and prescribed
additional medicine...
The
leverage ratio does exactly that: It doesn’t stop at measuring
risk-based capital ratios but checks a bank’s balance sheet
entirely.
For
the Basel Committee, a major problem of the 2008 / 2009 financial
crisis was the “build-up of excessive on- and
off-balance sheet leverage while apparently maintaining strong
risk-based capital ratios”. This is why the leverage ratio
is now introduced as a complementary capital requirement. It is meant
to be simple, transparent, and non-risk based.
The
Basel III leverage is not intuitive. As you can easily grasp from the
above, leverage is something bad that we should avoid if we want to
benefit from a safe financial system. Why is it then that the Basel
Committee prescribes a minimum leverage ratio of 3 %? The
answer lies in the definition of the ratio:
Leverage
ratio = Capital measure / Exposure measure
This
definition is comparable to defining spinach as pasta and then saying
that all kids like spinach!
The
capital measure has not changed in BIS' recent publication. It
corresponds to Tier 1 capital which is the sum of
- the bank’s shares (including additional paid-in capital),
- retained earnings, and
- additional capital which is subordinated to general creditors and depositors, unsecured, perpetual or only exceptionally redeemable, and whose remuneration is at the bank’s discretion.
“A
simplistic leverage ratio would create a perverse disincentive for
banks to hold risk-free or very low risk assets such as cash or
government securities.”
Timothy
Adams – Institute of International Finance – 11 October 2013
New
is only the definition of the exposure measure. It now captures
- on-balance sheet exposures,
- derivative exposures,
- securities financing transaction (SFT) exposures, and
- off-balance sheet (OBS) items.
In
general, the exposure value corresponds to the pure accounting value.
On-balance
sheet exposures
On-balance
sheet exposures are all balance sheet assets, including on-balance
sheet collateral and collateral for SFT. Except for derivatives, they
are measured net of specific provisions and accounting valuation
adjustments. However, a netting of loans and deposits is not allowed
and assets shall not be diminished by collateral or other forms of
guarantees provided to the bank.
“Unfortunately,
as good as simplicity is as a goal, we need both leverage and
risk-weighting as compensating factors.”
Rodgin
Cohen – Sullivan Cromwell – 12 October 2013
Derivative
exposures
Derivatives
exposures comprise the replacement cost (RC) for current exposure
plus an add-on for potential future exposure (PFE). Banks should
calculate RC by marking the derivative contract to market; RC cannot
be negative. PFE is the product of the notional principal of the
derivative and an add-on factor. The latter depends on the underlying
of the derivative and its maturity.
Generally
speaking, collateral that the bank provides or receives shall not
affect the institution’s exposure under the derivative. Only if
collateral has been received in the form of cash, it might reduce a
bank’s derivatives exposure, subject to five cumulative conditions:
- The trade is cleared through a qualifying central counter-party.
- The parties mark the derivative to market at least daily.
- Collateral and clearing currency are the same.
- The cash amount covers the entire mark-to-market, subject to threshold and minimum transfer amounts.
- A single master netting agreement covers both derivatives and collateral.
National
regulators can tweak the above calculation if the parties trade the
derivative under an eligible bilateral netting contract.
Securities
Financing Transaction (SFT) exposures
SFT
exposures are assets recognized on the balance sheet as securities
financing transactions (namely secured lending and borrowing and
repurchase agreements). However, banks can deduct two types of
assets:
- Securities received under the SFT where the bank has recognized the securities as an asset on its balance sheet.
- Cash payables and cash receivables in SFTs with the same counter-party if the transactions have the same settlement date, the bank has a right to set-off, and the transactions are settled on a net basis.
SFT
assets are adjusted for counter-party credit risk. The adjustment
depends on the type of master netting agreement in place and the fair
value of securities received.
“The
current debate is not whether there should be a leverage ratio but
rather - Should it be the
binding constraint?.”
Timothy
Adams – Institute of International Finance – 11 October 2013
Off-balance
sheet (OBS) items
Off-balance
sheet items include
- commitments (including liquidity facilities), whether or not subject to unconditional cancellation,
- direct credit substitutes,
- acceptances,
- standby letters of credit, and
- trade letters of credit.
They
are converted into credit exposure equivalents by multiplying the
notional amount with a credit conversion factor (CCF) as detailed in
the Basel III leverage ratio framework.
The
Basel III leverage ratio will have to be disclosed by 1 January 2015.
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