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Basel Committee Rethinks Formula for Bank Leverage Ratios

Global Glimpses | June 26, 2013

The Basel Committee on Banking Supervision has announced major changes to how banks will be required to calculate leverage ratios, an effort intended to ease competitive concerns among member countries, address differences in international accounting standards, and further steer banks away from potentially risky derivative holdings.

The Basel Committee, comprised of central banks and regulators from 27 countries, is tasked with establishing international standards for bank capital and liquidity standards. Basel III, a comprehensive slate of reform measures, addresses bank leverage ratios and sets standards for non-risk-based capital holdings that are intended to serve as a backstop to risk-based activity. 

The Basel III leverage ratio, currently set at 3 percent, is calculated by dividing a bank's Tier 1 capital to its “exposure measure,” which includes both on-balance sheet and off-balance sheet risks. When its leverage ratio was first introduced in 2010, the Basel Committee made it clear that future adjustments were likely.  A consultation paper issued on Wednesday details the first official recalibration.

The updated proposal expands reporting requirements for derivatives included in the leverage ratio calculation. Securities financing transactions, including repurchase agreements, and securities lending and borrowing transactions, are now also part of the formula. 

“When the Basel III leverage ratio was first introduced at the end of 2010, the Basel Committee basically kicked the can down the road in terms of how derivatives and securities financing transactions would be accounted for in the denominator of the leverage ratio,” says Andrew Fei, an attorney at Davis Polk who advises on Basel III. The original document devoted a mere two paragraphs to those important topics.

The new consultation paper, however, details specific measurement methods. Fei says the intent is to bridge differences between U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), achieving a more uniform leverage measure for banks that operate under different, international accounting regimes. European accounting standards require more comprehensive reporting on derivatives that the U.S. does (gross vs. net positions), a difference that could give the latter's institutions a competitive advantage when meeting leverage ratios.

The concerted push to bring Basel III participants more in line with a standardized leverage ratio has been developing over many months.

Since the 1980s, U.S. banks have been subject to their own leverage ratio, which only takes into account on-balance sheet assets, not off-balance sheet assets, a Davis Polk client advisory explains. With limited exceptions, the minimum U.S. leverage ratio is generally set at 4 percent and a bank needs to have a U.S. leverage ratio of at least 5 percent to be considered “well-capitalized.”

In June 2012, the three U.S. banking agencies (Federal Reserve, Office of the Comptroller of the Currency and Federal Deposit Insurance Corporation) issued proposed rules to bring their regulatory capital framework more in line with Basel III.  Under those proposals, the Basel III leverage ratio would only apply to the largest and most internationally active U.S. banks. The rules would not apply the Basel III leverage ratio to any other U.S. entities, including community banks. 

Bank regulators are expected to soon finalize the U.S. Basel III rules. “It remains to be seen whether they will include the revised version of the Basel III leverage ratio,” Fei says.  

U.S. regulators have also discussed the possibility of increasing their leverage ratio to as high as 6 percent when they do approve final rules. Although not specifying a preferred percentage, a recent report by the UK's Parliamentary Commission on Banking Standards said the leverage ratio should be "substantially higher" than 3 percent.  Mervyn King, former governor of the Bank of England, had said that a ratio as high as 10 percent should be considered.

For countries that adopt the Basel III standards, the leverage ratio goes into full effect on Jan. 1, 2018. By Jan. 1, 2015, however, banks are required to begin disclosing their current leverage ratios.

In addition to a public comment process, the Basel Committee will conduct a Quantitative Impact Study on the proposed recalibration of the leverage ratio. Comments should be submitted by Sept. 20 by email to baselcommittee@bis.org.