The BoE leverage ratio: welcome relief or regulatory arbitrage?

“Asking for help isn’t a sign of weakness, it’s a sign of strength,” former US President Barack Obama said during a speech to American students in Virginia in the early days of his presidency. The reverse is true for banks – despite their systemic interconnectedness. 

Lenders fear calling for regulatory forbearance or using support facilities precisely because it shows they are not strong enough to stand alone. 

Post-crisis rules add another complicating layer. Prudential requirements can discourage banks from using proffered help, as these can cause minimum capital charges to increase.

So regulators have had to use cunning to encourage banks’ participation in schemes intended to prevent their untimely collapse. One such ploy was masterminded by the Bank of England in the tumult following the UK’s vote to leave the European Union. Concerned that firms under its supervision would shy away from using its liquidity facilities to help them through stressed periods, the BoE tweaked the leverage ratio by subtracting central bank cash from the exposure measure.

At a stroke, this freed banks from having to hold capital against their deposits at the BoE, meaning there would be no penalty incurred for building up a cash pile at the central bank. 

To deflect critics concerned the manoeuvre allowed UK banks to lower their capital requirements, the BoE decided to lift the minimum leverage ratio to 3.25%, from 3%, the following year. 

But Risk Quantum analysis suggests the bar was not raised high enough. In fact, the gap between the BoE’s measure of leverage and that used by the EU – which does not discount central bank claims – at large UK banks has increased steadily since the revised measure came into force three years ago. Put simply, UK banks are reaping ever-higher leverage capital savings through the BoE measure that far outweigh the 25bp uplift to their minimum leverage ratio requirement. 

If the UK financial system existed in a bubble, these figures would not be a big deal. But the fact that EU banks, which are subject to the tougher EU ratio, are at a comparative disadvantage to their UK peers should raise some questions among bankers and regulators alike. 

However, the BoE may yet find itself branded a regulatory pioneer. The finalised Basel III reform package explicitly permits national authorities to exempt central bank reserves from the leverage ratio. More countries could therefore follow the BoE in granting capital relief to banks. 

But they could all elect to apply the carve-out differently, leading to regulatory fragmentation – and the dilution of the leverage ratio’s ability to serve as a straightforward capital backstop.