My post on EU leverage ratios yesterday attracted some comments on twitter, which may haven been triggered by misunderstandings.
The CRR offers a short and clear summary of the Leverage Ratio definition in Article 429.1: “The leverage ratio shall be calculated as an institution’s capital measure divided by that institution’s total exposure measure and shall be expressed as a percentage.”
Beware of CoCos
The numerator, the capital measure, is Tier 1 capital, which includes CoCos (Additional Tier 1). This means that you have to be mindful when you express a desire to fire up leverage ratios, and don’t want them to rely on weak capital elements. The CRR imposes no limits on the amount of CoCos that the Tier 1 ratio can include. I commented on this some weeks ago, when Switzerland presented its leverage ratio rules.
There is no such thing as a simple ratio
The denominator of the Leverage Ratio is the exposure measure, not total balance sheet assets. The exposure measure includes off-balance sheet items. As a result, the denominator has become more complex, see Matt Levine’s observation on this: The Leverage Ratio rules are “based on judgments about which activities are safe and which are risky, which can be made more expensive in the interests of safety and which need to be preserved as is.”
In other words, the Leverage Ratio is a risk-weighted ratio in disguise.
The EU update
In October 2014, the EC updated the Leverage Ratio rules to align them with the Basel III leverage ratio rules, see this memo.
More importantly, the Leverage Ratio definition is now uniform across jurisdictions. The updated definition faithfully implements the Basel revised rules text as agreed by the GHOS (Governors of Central banks and heads of supervision of Basel Committee member jurisdictions). This is important because the leverage ratio should be comparable internationally.
The main amendments of the update are:
1. A clarification that for SFTs collateral received cannot be used to reduce the exposure value of said SFTs but that cash receivables and payables of SFTs with the same counterparty, and subject to strict criteria, can be netted;
2. A calculation and reporting period defined as at the end of the reporting period (quarter) instead of a three-month average.
3. Using the credit risk conversion factors (CCFs) of the standardised approach for credit risks of 0%, 20%, 50%, or 100% depending on the risk category, subject to a floor of 10 %, instead of the 100% weighting of off-balance sheet exposures;
4. For derivatives, cash variation margin received can be deducted from the exposure value;
5. Written credit derivatives are measured at their gross notional amount instead of at their fair value, but fair value changes recognised through P&L (losses) can be deducted from the notional amount. Also, offsetting of protection sold with protection bought is allowed, subject to strict criteria;
6. The deduction from the LR of the client leg of transactions with a Qualifying Central Counterparty (QCCP) where the institution has no obligation to reimburse the client if the QCCP would default as it does not create leverage.
7. The scope of consolidation will be the regulatory scope of consolidation used for the risk-based framework instead of the accounting scope of consolidation.