Monday, September 5, 2016

The Basel III Leverage Ratio – Leverage Trade Finance?

No, introducing a leverage ratio in the Basel III framework does not leverage trade finance. It rather kills it. You can debate whether it actually leverages the security of the financial system, even though this is, at least, its purpose.


The leverage ratio is meant to complement the risk-weighted capital ratios. In other words, whereas the capital ratios compare different forms of capital and risk-weighted exposure, the leverage ratio compares Tier 1 capital and non-risk weighted exposure.

Here is the formula, to be calculated quarterly:

Leverage Ratio = Tier 1 Capital / Exposure Measure 3 %

It’s perhaps a bit intriguing that the leverage ratio is here a minimum ratio as we are more used to see leverage as something bad (“The more your company is leveraged, the more dangerous it is.”). In banking, it’s the other way round.

Tier 1 Capital is the smallest form of capital. Extremely simplified, we add up equity, retained earnings, and other paid-in and not subordinated capital instruments.

The fact that the numerator is the smallest capital form makes the denominator even more important: The Exposure Measures comprises

  • On-balance sheet exposures +
  • Derivative exposures +
  • Securities financing transaction (SFT) exposures +
  • Off-balance sheet (OBS) items

Trade Finance increases OBS, decreases the leverage ratio, and harms bank profitability.

Trade finance consists of letters of credit and guarantees. Both are off-balance sheet items. Hence, a trade finance instrument issued by a bank requires a specific amount of Tier 1 Capital to keep the leverage ratio above the 3 % threshold.

So far, so bad. But this is actually not all.

Let’s remind ourselves how we calculate RWA for trade finance instruments when it comes to capital ratios:

  • 1st step: We multiply the nominal with a credit conversion factor as follows

  • 2nd step: We multiply this converted value with a probability of default (which depends on the rating of the Instructing Party) and deduct the result from the converted asset.

The 2nd step is skipped when it comes to calculating the leverage ratio. This is precisely the raison d’ĂȘtre of the leverage ratio.

But the 1st step is altered as well because the proposed credit conversion factors are actually higher:

Syndication doesn’t lead you anywhere.

If you (I suppose you are a trade finance banker!) don’t have enough by now, let me add a final surprise well hidden in an Annex called “Basel III Leverage Ratio Framework”:

[…] Banks must not take account of physical or financial collateral, guarantees or other credit risk mitigation technique to reduce the leverage ratio exposure measure.”

I wish good luck to a company which has just secured a multi-billion export contract, needs a performance guarantee for such contract, and is looking for a bank to issue this guarantee without being able, from a leverage ratio perspective, to syndicate its exposure.

What’s next?

The Basel Committee on Banking Supervision has proposed the above rules in April 2016 and envisages application in January 2018.

Until then, there is plenty of time to debate and, hopefully, amend the proposals.