Review and evolve: The leverage ratio today, yesterday and tomorrow

By Rebekah Tunstead | 26 November 2019

Since regulators stepped up their inspections of leverage ratios about a decade ago, banks have been jittery about reporting requirements, and how much control they have relinquished in the name of transparent markets. Clearing, repo and a host of other desks have reconstituted the way they do things, much to their chagrin.

But the formalities of the processes that have taken the market to where it is today have been long, arduous, though well-intentioned. The Basel committee’s aim to stem a build up of too much systematic risk by requiring globally systemically important banks to have a capital buffer and a host of disclosure requirements was clearly not what the banks wanted and it’s difficult to tell just exactly the impact it’s had on the market.

And questions have been raised over the impact of the rules on repo markets. A rise in demand in the market has seen prices rise, with a smaller increase in transaction volumes – at least in the UK according to the Bank of England (BoE), in May. In that working paper, the bank said the “leverage ratio may reduce dealers’ ability and/or willingness to act as repo market intermediaries” which “may have implications for the resilience of repo markets in future periods of stress”.

Likewise, concerns remain around the increase in costs for interest rate derivative transactions which under the requirements cannot use initial margin to reduce exposure. In a working paper last year, the BoE said that the leverage ratio “had a disincentivising effect on client clearing, both in terms of daily transactions as well as the number of clients.” To address the issue, the Basel Committee said in June that it was looking to “align the leverage ratio measurement of client cleared derivatives with the measurement determined per the standardised approach to measuring counterparty credit risk exposures.”

No leverage ratio relief

There have been many updates to the regulation since it was first introduced.

Supplementary leverage ratio - the US equivalent to the Basel III tier 1 leverage ratio - requires the largest US banks to hold three percent leverage ratio, while tier one holding companies need to hold an extra two percent of a buffer.

US regulators finalised changes to the requirement on November 19. The Economic Growth Regulatory Relief, and Consumer Protection Act allows banks involved in custody and asset servicing “to exclude qualifying deposits at certain central banks from their supplementary leverage ratio”. According to the Federal Reserve, the rule - which will come into effect on April 1, 2020 – applies to BNY Mellon, Northern Trust Corporation, and State Street Corporation, and their depository institution subsidiaries.

Similarly, the European Capital Requirements Regulation allows for competent authorities to exclude exposure from the leverage ratio calculation if it fulfils a number of conditions. However, in 2018, six French credit institutions took a case against the European Central Bank (ECB) after it refused to allow the banks to exclude special deposits with state investment institution Caisse des Dépôts et Consignations from their leverage ratio calculations. The ECB acknowledged that although the conditions had been met it had the option to refuse the exclusion requested. The Court of Justice of the European Union annulled the ECB’s decision.

In November last year, the Basel Committee published a revised leverage ratio standard. The revision allows banks to use the standardised approach for calculating counterparty credit risk (SA-CCR) for client exposures. This, the committee said, “would have the effect of allowing both cash and non-cash forms of initial margin and variation margin received from a client to offset the replacement cost and potential future exposure amounts of client cleared derivatives.” Further afield the Australian Prudential Regulation Authority is in the process of consulting authorised deposit-taking institutions on leverage ratio requirements to implement the committee’s standard, after it published a response letter on November 22.

Window dressing

One method of making leverage ratios appear healthier through manipulating an entity’s activity around an anticipated disclosure date, window dressing has been a key consideration by regulators in their updates and amendments to capital stress tests.

The Basel committee published in June final revisions to leverage ratio disclosure requirements. The update set out extra requirements for banks to “disclose their leverage ratios based on quarter-end and on daily average values of securities financing transactions.” Through the comparison of two sets of values, it is hoped this will create a better assessment of banks’ leverage during the reporting phase. Directly addressing window dressing, the committee said supervisors may need to consider more frequent reporting and monitoring of transaction volumes and inspections of a bank’s ability to observe minimum requirements, as well as “additional public disclosures on the impact of volatility in transaction volumes between reporting reference dates”.

But despite warning statements from regulators, in September, Risk.net reported evidence that window dressing was still in practice. The publication had seen a memo outlining an agreement between a US bank and a European bank to briefly swap assets during the stress tests in their respective jurisdictions.

On November 7, the EBA updated the final methodology and draft templates for the 2020 stress test. The regulator said that the stress test would be launched in January 2020 which it said would “give banks sufficient time to prepare for the exercise”. The updated methodology states that UK banks will be included in the sample, unless the country leaves the European Union during the exercise.

But the European stress testing exercise remains under review. In July the EBA launched a call for research papers on the future of stress tests within the banking sector. The regulator is scheduled to have a workshop on November 27 and 28 with economist and researchers from central banks and supervisory authorities to discuss the approaches, governance, and methodologies of stress test exercises in the European banking industry.

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