Basel’s New Leverage Ratio: One Step Forward, Two Steps Back – Repost

It has become an old refrain. The Basel Committee on Banking Supervision proposes guidelines to improve banking sector safety. Banks and their lobbies with vast resources mightily fight back. The Basel Committee – which, due to its large, diverse membership, is highly politicized – weakens its proposed guidelines. 

This is a repost from the post of Mayra Rodriguez Valladares in the American Banker.

Unfortunately, the final leverage ratio released Sunday fits this pattern. No doubt champagne corks will be flying. Unfortunately, when the next banking crisis comes, the rest of us will share in the hangover headache, even if not imbibing.

The havoc very leveraged banks, especially U.S. ones, wreaked on the global economy during 2007 to 2009 strongly influenced the Basel Committee to include a leverage ratio in the 2010 Basel III reforms. While a historic and commendable inclusion, the non-risk-weighted leverage ratio was a mere 3% and did not include all on- and off-balance-sheet transactions in the denominator.

But, when in June 2013, the Basel Committee released proposed guidelines to strengthen the leverage ratio by expanding the instruments that need to be covered, I, like other proponents of financial sector reform, welcomed the update.

I certainly expected strong pushback against the proposed, leverage guidelines by global systemically important banks, because most needed to increase retained earnings or raise equity or reduce their derivatives’ trading, repo transactions, dividends or bonuses to be in compliance. Indeed, the lobbying against the June 2013 proposed leverage ratio has been fierce and perhaps successful. If the Basel Committee’s final leverage guidelines are accepted by member countries, GSIBs, especially U.S. ones, will benefit greatly in capital savings, meaning that, when unexpected losses materialize, the rest of us, like in 2007-9, will be left to clean up the mess.

While Basel kept its proposed leverage ratio at 3%, there are five major changes in the new guidelines that significantly impact the ratio’s denominator and essentially help banks reduce their derivatives exposures for capital calculation purposes significantly through how derivatives are represented on the balance sheet or through netting. By lowering derivatives exposures, the capital required for the leverage ratio will be much lower, potentially endangering all of us from banks that in reality still remain too leveraged.

A significant win for U.S. GSIBs is that the leverage ratio will use the same credit conversion factors that are used in the Basel Accord’s standardized framework. CCFs enable banks to have lower capital requirements for off-balance-sheet transactions. This helps U.S. banks enormously since derivatives are off-balance-sheet in their generally accepted accounting principles unlike in International Accounting Standards. The June 2013 proposal advocated a much stricter uniform 100% credit conversion, essentially converting off-balance-sheet transactions to on-balance-sheet equivalents.

Two of the new measures help banks use netting to reduce their derivatives exposures resulting in significant capital savings. U.S. and European GSIBs will be pleased that limited netting with the same counterparty will be allowed under certain conditions. This reduces a bank’s leverage ratio and, hence, the capital it needs. Also, under specific conditions, the cash variation margin associated with derivative exposures may be used to reduce the leverage ratio’s exposure measure.

Under the new guidelines, a clearing member’s trade exposures to qualifying central counterparties associated with client-cleared derivatives transactions may be excluded when the clearing member does not guarantee the performance of a QCCP to its clients. This exemption was granted because a major premise of the 2009 G20’s goal was to reform the global derivatives market and the Basel Committee did not want to discourage participants from using QCCPs.

Sellers of credit derivatives also received relief. The effective notional amounts of sold credit derivatives included in the exposure measure may be capped at the level of the maximum potential loss. Moreover, the committee will have some broadening of eligible offsetting hedges.

Under the final guidelines, top derivatives banks like Bank of America, JPMorgan Chase, Citigroup and Wells Fargo, can use the netting allowed to reduce their derivatives exposures in the magnitude of over $100 billion. This is extremely significant since the capital allocation required by the leverage ratio is then substantially reduced, potentially leaving banks significantly undercapitalized in the event of an unexpected loss. There is no guarantee that in a period of stress, collateral will materialize quickly and, when it does, its value will likely have declined. Liquidity and operational risks can materialize very quickly and detrimentally.

To date, U.S. lobbying has largely focused on the version of the leverage ratio the Federal Deposit Insurance Corp. released back in July. Regulators are recommending U.S. bank holding companies and deposit-insured subsidiaries have a leverage ratio of 5% and 6%, respectively. As one of the two original members of the Basel Committee, the U.S. will be under pressure to abide by the committee’s new leverage ratio in the name of international harmonization.

However, the Federal Deposit Insurance Corp. has a key interest in a strong leverage ratio, since Dodd-Frank’s Title I and II give it new and onerous responsibilities for large, internationally active banks. It is in the interest of the FDIC to have healthy and, also preferably, smaller banks.

Even before the Basel Committee met on Sunday, journalists such as Huw Jones of Reuters suggested easing the leverage ratio would help the economic recovery. Jones’ article, in particular, excludes different points of view and also fails to provide proof that a less stringent leverage ratio will lead banks to lend more.

The global financial crisis proved that when banks have light capital requirements and lax supervision, they will invest in riskier transactions. In fact, there is nothing to suggest, especially given the low interest rate environment, that lighter capital rules would encourage banks to lend more and stimulate a needed global recovery.

In the U.S., lobbyists are also likely to renew their trite argument that a stronger leverage ratio puts U.S. banks at a competitive disadvantage globally. But, as I have previously argued, what truly puts our country at a competitive disadvantage is the tremendous negative impact very leveraged banks can and have had on the American economy.

A strong leverage ratio is a necessary supplement to Basel’s current risk-weighted asset credit risk measurement and is crucial to making banks better capitalized to sustain unexpected losses. A comprehensive leverage ratio could be an important tool in reducing the size of GSIBs, many of which are too big to be managed or supervised effectively enough to protect taxpayers.

Mayra Rodríguez Valladares is managing principal at MRV Associates, a New York-based capital markets and financial regulatory consulting and training firm. She is also a faculty member at Financial Markets World.