That feeling when you notice that EU leverage ratio requirements are at risk

This week, the EBA and BCBS published the Basel III monitoring results. They show a further improvement of European banks’ capital positions, largely fulfilling the future regulatory capital requirements, with only a very small number of banks suffering from potential capital shortfalls.

I found Figure 9 of the EBA report interesting. It shows the evolution of the quotient of Risk Weighted Assets (RWA) to the leverage ratio exposure measure over time, where Group 1 banks (blue) are large banks, and Group 2 banks (yellow) are smaller banks:

The quotient has declined over time, which is the result of de-risking. Banks lowered their exposures to high-risk assets and increased their exposures to low-risk assets. This is the Basel III risk-based ratio requirements framework at work.

If only the risk-based ratio requirements mattered, then banks would keep decreasing the quotient of RWAs to Total Assets. This then could lead to large balance sheets dominated by low-risk assets (in particular residential mortgages).

However, there is also a leverage ratio requirement, which acts as a backstop: it limits the incentive to increase the size of the balance sheet.

Banks therefore manage two constrains, one imposed by the risk-based ratio requirements and the other imposed by the leverage ratio requirement.

How do they manage? Well, the graph shows dotted lines that banks target to manage both constraints. If the quotient is below the dotted blue line (for large banks) or the yellow line (for smaller banks), this implies that the leverage ratio, rather than the risk-based Tier 1 capital ratio of 8.5% (minimum requirement plus the capital conservation buffer), is a binding constraint.

In other words, a bank that finds itself above the relevant dotted line will try to increase its risk-based ratio and decrease RWAs. A bank below the dotted line will try to increase its leverage ratio and decrease total assets.

The graph shows that banks managed the first constraint particularly well: they ditched assets with high risk weights; which in practice means that SMEs found it hard to borrow from banks.

That feel.

But the downward trend also highlights a looming issue: the Leverage Ratio has increasingly become a problem. This may be a bit of a worry, given that the EBA report also notices that the leverage ratio has become a binding constraint in particular for large banks. And we know that large banks are influential: they may collectively try to convince politicians to relax leverage ratio requirements. With the upcoming EBA assessment of the leverage ratio rules*, this may be a worry indeed.


* See Article 511 of the CRR.