Time for BoE to rethink the leverage ratio

The Bank of England has always been at the forefront of innovation. Whether it was about leaving the gold standard in 1931 or installing the first non-UK citizen as governor with Mark Carney in 2013, the Old Lady of Threadneedle Street is often ahead of the curve. 

In the aftermath of the UK’s vote to leave the European Union, the BoE pioneered a new way to encourage banks under its supervision to tap its liquidity facilities and navigate through the stressed period that lay ahead. 

With the stroke of a pen, the BoE tweaked the leverage ratio by subtracting central bank cash from the exposure measure. This meant UK lenders were freed from having to hold capital against their deposits at the central bank.  

The BoE also increased the minimum required ratio to 3.25%, from 3%, to prevent banks reducing their leverage capital levels below prudent levels in response. However, the move hasn’t stopped UK banks from reaping ever-higher leverage capital savings that far outweigh the 25-basis point uplift to their minimum leverage ratio requirement. 

A Risk Quantum analysis shows the top five UK banks waived a record $1.02 trillion off their leverage ratio exposures in the first three months of 2021 – the most since the UK and the EU leverage regimes diverged. As a result, the UK leverage ratio of these banks stood 80bp higher, on average, than it would have done if the EU leverage ratio regime had applied. 

To put it another way, the gap between aggregate exposures under the UK method versus the EU method has grown from 6% in 2017, to 13% this year. The trend is unlikely to reverse any time soon. 

The move first introduced by the BoE has since been replicated by a number of central banks, including the Federal Reserve and the European Central Bank. But unlike the BoE’s, their exceptions to the rule came with expiry dates of March and June 2021, respectively. 

Many voices within the banking industry have called on the Fed and the ECB to keep the relief measures in place, arguing the market is not out of the woods yet. So far, these calls have gone unanswered. 

All things being equal, UK banks are set to keep gaining from the relief expiry in other jurisdictions, putting them at a comparative advantage to their overseas peers once again. 

Moreover, the regulatory fragmentation that will result from the disparity of treatment could weaken the reason for having a leverage ratio in the first place. As the financial industry slowly re-emerges from the Covid-19 pandemic, it might be time for the UK regulator to reconsider whether this is still the right approach.